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C0EXRIGHT DEPOSIT. 



THE DEVELOPMENT OF 
FEDERAL RESERVE POLICY 



THE DEVELOPMENT 

OF FEDERAL RESERVE 

POLICY 



HAROLD L". reed 



PROFESSOR OF BANKING AND FINANCE, WASHINGTON UNIVERSITY 
SAINT LOUIS 




BOSTON AND NEW YORK 

HOUGHTON MIFFLIN COMPANY 

Zte Mtitxeitt Ij^vtis Cambrtbge 

1922 



t3 






COPYRIGHT, 1922, BY HAROLD L. REED 
ALL RIGHTS RESERVED 



3^ 



CAMBRIDGE • MASSACHUSETTS 
PRINTED IN THE U.S.A. 



OCT 13*22 

C1A683655 



..^..-. 1 



PREFACE 

Owing to the unusual character of the period during 
which its policy has been developed, many misconceptions 
have become current regarding the nature and purpose of 
the Federal Reserve banking system. Some of these mis- 
conceptions are so far-reaching as to create serious dif- 
ficulties for its management. No central banking system 
can be administered efficiently in an atmosphere of preju- 
dice and misunderstanding. The business public, in its 
appraisal of the system's management, must be led to 
apply the tests of sound principles of economics and 
finance rather than those rnerely of immediate, individual 
advantage. It, accordingly, has been the writer's en- 
deavor to do what little his capacities permit to stimu- 
late a proper spirit of inquiry regarding Federal Reserve 
matters. 

It has appeared to the writer that a careful examina- 
tion of the development of the reserve system could be 
made most opportunely by one not connected with its 
management. As a minor spur to the writer's efforts 
there has been the belief that no study offers superior op- 
portunities for investigating the working of the principles 
of money and credit under contemporary conditions of 
business and industry. While the book was written for 
the general reading public, rather than for classroom 
purposes, it may serve as a second book to follow the 
reading of one of the elementary texts in college courses 
in Money and Banking. 

On this occasion the writer would like to express his 



VI 



PREFACE 



gratitude to those who have helped him to sustain his in- 
terest in finance and economics. Among these he would 
like to mention the names of Professor Kemmerer, of 
Princeton University; Professor Davenport, of Cornell 
University; Dean Joseph French Johnson, of New York 
University; Dean Turner, of New York University; 
Dean Gephart, of Washington University, now Vice- 
President of the First National Bank of St. Louis; Pro- 
fessor Willcox, of Cornell University; and Professor A. S. 
Johnson, at present a member of the editorial staff of the 
New Republic. Professor Allyn A. Young, of Harvard 
University, has been a constant source of inspiration. 
April 30, 1922. 



CONTENTS 

I. The Working of the Regional System I 

II. Check Collections and Clearances under the 
Federal Reserve 20 

III. State Bank Membership in the Federal Re- 
serve 50 
^ IV. Advances of Reserve Banks — Rediscounts 70 
V. Direct Collateral Advances to Member 

Banks 97 

VI. The Development of the Trade Acceptance 105 

VII. Agricultural Credit under the Federal Re- 
serve 128 

VIII. The Development of the Bank Acceptance 154 

IX. The Open-Market Operations of Reserve 
Banks 185 

X. Advances of Reserve Banks — Note Issues 205 

XI. Advances of Reserve Banks — Deposits and 
Reserves 221 

XII. Federal Reserve Development, November, 

1914, TO December, 1916 239 

Early Problems of Organization 

XIII. Federal Reserve Development, January, 1917, 

TO April, 1917 261 

Financial Preparation for War 

XIV. Federal Reserve Development, May, 191 7, to 
November it, 191 8 267 
War-Time Credit Expansion 



viii . CONTENTS 

XV. Federal Reserve Development, November 12, 

1918, TO May, 1920 292 

The Period of Post-War Credit Expansion 

XVI. Federal Reserve Development, May, 1920, to 

THE Present Time 316 

The Period of Business Readjustment 

Index 345 



THE DEVELOPMENT OF 
FEDERAL RESERVE POLICY 



THE DEVELOPMENT OF 
FEDERAL RESERVE POLICY 



CHAPTER I 

THE WORKING OF THE REGIONAL SYSTEM 

In the matter of structure, organization, and administra- 
tion, the most characteristic feature of the Federal Reserve 
banking plan is the system of district reserve banks. The 
regional system was also the most surprising outcome of 
the legislative planning which preceded the framing of the 
final provisions of the act. Since 1907 the question of 
banking reform had revolved about the idea of establish- 
ing, for the entire country, a single large and powerful 
institution which should hold a portion of the reserves of 
the member institutions and whose advances should be 
controlled by a single board or directorate. It was felt by 
many that a banking organization more centralized in con- 
trol and resources offered far greater possibilities of avoid- 
ing credit collapses than our old decentralized system. 
Demands for banking reform were thus predicated upon a 
belief in the desirability of a single central bank. While it 
was anticipated that such a bank must establish local 
branches or agencies, it was not expected generally that 
there would be established in each of a dozen different dis- 
tricts a bankers' bank which should deal for the most part 
only with the banks of its own territory. It was not antici- 
pated that a group of independently operating bankers* 
banks would be set up, with no one bank possessing domi- 



2 FEDERAL RESERVE POLICY 

nating authority. It was not predicted that the board 
with general control would not be allied to any one bank 
in particular. 

The motives influencing the legislators to this generally 
unf ore told conclusion are now well known. Despite the 
admittedly great possibilities of a central bank, there were 
many fears that such an institution would employ its 
resources with partiality. Recollections of the old preju- 
dices against such an institution surviving from the time 
of Andrew Jackson made it appear the part of political 
wisdom to the Congressional leaders of both parties to 
soften the emphasis upon the idea of control by the direc- 
torate of one all-powerful institution. In the Aldrich Bill 
the plan which might be said to represent the Republican 
attempt to secure banking reform, the idea of cooperation 
and not of control was to be suggested by the name of the 
new system. It was to bear the name, not of a bank, but 
rather of the National Reserve Association. Furthermore, 
its machinery was to be such as not to exert any large 
measure of continuous control. By the issue of notes 
carrying a progressively increasing tax, it was designed 
primarily to offer relief in periods of emergency and threat- 
ened credit collapse. 

The underlying theory of the Federal Reserve system 
was somewhat different. The reserve institutions were to 
bear the names of banks, and it was hoped that they would 
operate more or less continuously. But lest the objections 
to the idea of a central bank should prove too strong, 
attacks were to be parried in another way. There was to 
be no single, all-powerful central bank. Twelve regional 
banks, distinct in membership and direction, were to be 
set up, their several operations to be harmonized and 
coordinated by a single board. The Democratic plan, the 
Federal Reserve plan, was thus based upon the idea of 



THE WORKING OF THE REGIONAL SYSTEM 3 

preserving for the banks of each locality as much control 
over the district bankers' bank as seemed financially expe- 
dient. Such a solution was indeed typical for a party 
whose political traditions are founded so largely upon the 
doctrine of States' rights and local autonomy. 

The wisdom of the regional idea was attacked strenu- 
ously by many. At the time of greatest controversy, 
however, the ultimate manner of the operation of the 
Federal Reserve system was more or less a matter of 
doubt. There was no experience by which to measure the 
importance of the numerous objections. But now, after 
nearly a decade of experience, the value of the regional 
idea can be appraised more accurately. What, then, does 
past operation suggest regarding the practicability of the 
plan? An inquiry, such as this projects, renders it desir- 
able to recall some of the earlier points upon which the 
regional system was attacked. An advantage of restating 
these objections now is that by virtue of recent experience 
the haziness which beclouded the form of their original 
statement may be avoided, in part at least. 

In the first place, it was felt that the regional plan would 
create too much temptation to the frequent use of the 
reserve bank's resources. The basic idea was to bring the 
bankers' bank more close to the member institutions. 
Direction was so planned as to subject its management to 
pressure and influence exerted by the member banks of 
the locality. Six of the nine district directors were to be 
chosen by the member banks. Moreover, the regional idea 
was asserted to be merely a substitute for the plan which 
contemplated only occasional or emergency relief for the 
member institutions. It was evident to all that many 
dangers must lie in the path of any system designed to 
exercise day-to-day control over the money market. To 
render any such control effective the advances of the re- 



4 FEDERAL RESERVE POLICY 

serve banks must be large. The acceptance of ^the Euro- 
pean ^ rule of procedure — keeping the central bank's rate 
above the market — might leave the reserve banks a piece 
of unused and costly machinery. In view/of the concentra- 
tion of reserve money and the consequently great possi- 
bilities of pyramiding credits, it was perceived that an 
unexampled expansion of bank advances might take place. 
In short, the regional plan, instead of guarding against, 
seemed actually to make provision for, price inflation. 

It was asserted, furthermore, that the regional idea was 
solely a compromise, the outgrowth of the desire to avoid 
popular objection. Considerations of financial wisdom 
were held to have been subordinated to those of political 
expediency. Few have been the occasions when compro- 
mise has proved successful in matters financial, and it 
scarcely could be hoped that banking reform would con- 
stitute an exception. If our old difficulties were due prima- 
rily to decentralization, in credit control, note issues, and 
reserve holdings, the greatest advantage could be realized 
only by utilizing to the utmost the idea of centralization. 
The greatest degree of benefit could be obtained only by es- 
tablishing a single bankers' bank dominating the member 
institutions of the entire country. Any other solution 
must perpetuate among the reserve banks the old evil 
formerly pertaining to the individual banks — scrambling 
for reserves in periods of emergency and excessive compe- 
tition in the period of business activity. To be sure, 
attempts could be made to unify the operations of the 
reserve banks by granting certain powers of control to the 
Federal Reserve Board. But this, it was argued, would be 
merely a patchwork device. The regional system must 
limit somewhere the possibilities of centralized control 

^ Only in a very general sense is it correct to imply that the dominating policy 
of European central banks has been to keep the official rate above the market 
rate. There are, of course, many exceptions. 



THE WORKING OF THE REGIONAL SYSTEM 5 

and concerted action. Otherwise what would be its advan- 
tage over a single central bank? 

Opponents of the plan argued also that it represented an 
attempt to isolate different territories of finance, to estab- 
lish sectionalism in an impossible field. Finance, any more 
than trade, cannot be confined within artificial borders. 
The call-rate policy of the metropolitan bank may affect 
the Southern cotton planter in as real (though a more in- 
direct) a manner as the credit policy of his own local bank. 
Even under our old faulty banking system many were the 
means by which bank capital could be transferred from 
one locality to another. The call rates of city banks must 
exert some influence upon the place of investment of sur- 
plus bank capital. Our various banking channels cross 
somewhere, even if in a haphazard manner. The rivulets of 
credit, sluggish though they be, carry eventually their 
deposits to the deeper channels. If the various districts 
of the country are related in fact, why not recognize this 
relationship in the structure of the banking system? Fail- 
ure to recognize it must create only difficulty. If twelve 
different open markets for commercial paper exist, wherein 
has correction been found for the old evil — inability to 
mobilize efficiently a large portion of our surplus bank 
reserves at the point of greatest need? 

These were some of the more earnestly developed 
attacks upon the regional plan. Let us next consider as 
completely as may be their respective merits. In doing 
this, however, an attempt must be made to avoid for the 
present those aspects of the problem which involve ultra- 
complicated features of reserve banking. 

In the light of recent experience much justification is 
afforded the view that the regional system is peculiarly 
susceptible to undue credit expansion. Local pressure for 
enlarged credit grants is always most intense. Business 



6 FEDERAL RESERVE POLICY 

thrives on easy money; rising prices usually create the 
situation of a widening margin between costs of produc- 
tion and sale proceeds. Those who are injured by price 
inflation, those whose money incomes are incapable of 
quick adjustment, exert only feeble pressure upon the 
banking administration. Wage-earners scarcely ever 
emphasize this cause of their woes; they are much more 
prone to employ the devices of strikes and concerted 
action. The middle class has no influence upon the bank- 
ing administration. Occasionally entrepreneurial activity 
is injured by the rising scale of prices, as, for instance, in 
the public utility and railroad fields. But the petitions of 
industrial entrepreneurs, in the same manner as those of 
the wage-earners, are scarcely ever addressed to the bank- 
ing administration. Prayers for higher rates offer greater 
prospects of relief. Because of the nature of things, it is 
peculiarly necessary that the banking structure be such as 
to make easy denial of demands for excessive credits. It is 
necessary that banking control be lodged in the hands of 
those well equipped to resist the credit demands of those 
who are not responsible for the interests of all classes in 
society, and who do not have in mind merely the short- 
time requirements of business. 

One means of ensuring conservatism in the operations 
of the central bank is to emphasize the emergency charac- 
ter of the institution. Let the rates on the advances of the 
central institution be normally above the market rate. 
Advances from the central bank are thus rendered unprofit- 
able on ordinary occasions. But aid, costly though it be to 
secure it, is available for periods of credit strain. 

It has been stated previously that the regional idea is 
based on the theory of continuous control of the money 
market. It necessitates accordingly constant employment 
of reserve funds. This, in turn, imposes the necessity of 



THE WORKING OF THE REGIONAL SYSTEM 7 

keeping the rates sufficiently low to occasion demand for 
the funds of the reserve system. The rule of remaining out 
of the market except in emergencies is not so easy of 
acceptance under the regional system. Control by member 
banks is too direct. And so far as the particular facts of 
the reserve system are concerned, the regional idea was 
invoked as a substitute for a previous plan in which the 
emergency character of the institution was emphasized. 

It may be that in the course of time a means may be 
developed whereby the volume of reserve advances may be 
stabilized in relation to the needs of trade even though the 
reserve banks are kept continuously in the market. In the 
opinion of the writer, however, the principles for regulating 
the volume of reserve advances have not yet been formu- 
lated with sufficient definiteness.^ 

The above paragraphs should not be interpreted as 
advocating absolute aloofness from the market except in 
periods of strain. Those who stress the emergency charac- 
ter of the reserve banks would admit the necessity of some 
measure of continuous functioning. But such operations 
need not be so extensive in volume. It was asserted, fur- 
thermore, that if the share contributions of member banks 
to the capital of reserve banks could be returned, there 
would be even less pressure to find continuous use of 
reserve bank funds. If the idea of emergency advances 
only were developed, could not the reserve institutions 
develop enough investment power without share capital 
contributions from member banks? Reserve banks would 
still possess the resources based upon their holdings of 
member banks' reserves. But further discussion of this 
aspect of the problem can best be postponed till a later 
chapter.* 

»See infra, Chapter XVI. 
»Seew/m, Chapter XII. 



8 FEDERAL RESERVE POLICY 

In reply to the second objection, that the regional plan 
was based upon the idea of divorcing various banking 
channels, it was replied that the scheme represented no 
more sectionalism than existed in fact. Attention was 
called to the great differences in banking customs and 
needs of the various districts of the country. It was 
asserted that nowhere in the world was there an illustra- 
tion of a central bank successfully dominating so large and 
diverse a banking territory as that of continental United 
States. In the words of H. P. Willis: ' 

So far as area is concerned, then, there would be room in the 
United States for a number of institutions corresponding to the 
total number of central banks throughout the European con- 
tinent. The mere fact that international lines divide the Bank 
of France from the Bank of England or the Bank of Germany 
has no relationship to the economics of the situation. It is a 
fact that no such extent of territory as the United States is dealt 
with by one single central bank. The Federal reserve system, 
with its series of reserve-holding institutions, therefore, does 
in fact correspond much more nearly to European practice than 
would a single central institution with branches. Each Federal 
reserve bank includes within its district a territory which, as 
the nation expands and its business increases, will rank with 
the territory tributary to one of the European central insti- 
tutions. 

From the point of view of directness and efficiency in 
administration, justification for Mr. Willis's remarks is 
clear. The regional character of the system has eliminated, 
undoubtedly, many anticipated difficulties of direction. 
But has this been accomplished at the expense of destroy- 
ing all possibilities of financial cooperation between the 
various reserve banks? Has the reserve system meant the 
segregation of financial territories and the consequent de- 
struction of any effective means of establishing a country- 
wide market for commercial paper of various origin, in 
» The Federal Reserve, p. 128. 



THE WORKING OF THE REGIONAL SYSTEM 9 

such a way as to enable the surplus funds of the country to 
be mobilized effectively? More precisely, have the reserve 
banks shown willingness to aid each other, by means of the 
rediscounting or direct purchase of each other's paper? 

In developing this inter-district harmony the succession 
of events has favored the administration. In the early 
years of operation, the period when no past experience in 
cooperation was possessed, a time accordingly when at- 
tempts to secure mutual aid would be difficult, there was 
little demand for this sort of reserve activity. Due to the 
reduction of reserve minima under the terms of the act and 
to the importation of gold from abroad, reserves of all the 
district banks were generally high. When the need of 
inter-district aid did develop, the Nation was engaged in a 
war so enveloping as to render apparent to all the neces- 
sity of subordinating considerations purely of sectional 
advantage. In such a situation it was easy for the Board 
to insist, in the determination of the inter-district shifting 
of funds, upon principles which ordinarily might have 
created some objection. At a time when so many devices 
of expansion were available, concessions by one bank 
would not necessarily impair its own lending power. 
Accordingly, as a guiding principle, reserves were to be 
equalized between the various district banks regardless of 
the cause of any bank's need for aid. 

The accompanying table on page 10 Indicates the volume 
of such inter-district operations during some of the years 
when their amount was exceedingly heavy. 

Needless to remark, operations so large in volume have 
affected greatly the reserve positions of the district banks 
on numerous occasions, increasing the reserves of some and 
lowering those of others. Indicative of this is the accom- 
panying table on page 11.^ 

*See Report of the Federal Reserve Board for 1919, p. 8. 



lo FEDERAL RESERVE POLICY 

Inter-District Movement of Discounted and Purchased Paper' 





For the Year 1918 


For the Year 1919 


For the Year 1920 


Bank 


Excess 

Move- 
ment 

FROM 2 


Excess 

Move- 
ment 

TO* 


Excess 
Move- 
ment 
from 


Excess 

Move- 
ment 

TO 


Excess 
Move- 
ment 

FROM 


Excess 
Move- 
ment 
to 



In Thousands of Dollars * 



Boston 


$ 92.046 




$ 131,165 






$ 986,280 


New York .... 


329,491 




996,412 




$ 764.219 




Philadelphia . . 




$ 56.562 


826.521 




191.872 




Cleveland 




207.534 




$ 463,909 




1.120.832 


Richmond .... 


68.732 




837.866 




699,675 




Atlanta 


77.722 




72,625 




250.510 




Chicago 




195,192 




1,583,864 




108.054 


St. Louis 


679 






181,029 


302.249 




Minneapolis . . 




82.907 




536,513 


253.096 




Kansas City . . 




27,564 




16.060 


386.137 




Dallas 


94.135 




337,398 




292.513 




San Francisco. 




93.046 




420.612 




325.105 


Total 


$662,805 


$662,805 


$3,201,987 


$3,201,987 


$3,140,271 


$3,140,271 



» The following extract from the Federal Reserve Bulletin for October. 1920 (p. 1015). is 
explanatory of the relation of the Gold Settlement Fund to the inter-district shifting of 
funds: 

"Originally established for the purpose of expediting the settlement of balances in gold 
between Federal Reserve Banks arising out of exchange and clearing operations, the shift- 
ing of funds from district to district in connection with rediscount transactions between 
Federal Reserve Banks has become one of the principal services of the fund under present 
conditions, and its efficacy has been strikingly exemplified during the heavy credit strain 
incident to the financing of our present crops. 

"When a Federal Reserve Bank, through the Federal Reserve Board, has been granted 
an extension of credit, and such extension has been allocated to some other Federal Reserve 
Bank, the extension is made effective through the transfer of title t9 gold in the gold settle- 
ment fund at Washington. The gold settlement fund . . . consists of deposits of gold 
which have been made by the Federal Reserve Banks and agents with the Treasury, which 
holds them in trust. . . . The gold in this fund is seldom physically moved, though it 
frequently changes ownership, transfer of ownership being effected through the mechanism 
of the fund without the need of moving. Ownership in the fund being represented by entries 
in the books of the fund, an applicant Federal Reserve Bank which has been granted credit 
extension receives its accommodation, and the gold to which it is entitled, through a credit 
entry in the gold clearing books of the Federal Reserve Board. Inasmuch as the gold 
settlement fund is a part of the gold reserve of each of the Federal Reserve Banks, this 
transfer amounts to shifting a given volume of reserve metal from a granting bank to the 
applicant bank. The effect is to transfer a corresponding amount of credit-granting or 
credit-lending power from the granting institution to the applicant. The latter is then at 
liberty to use it as it may see fit in extending further accommodation to the member banks 
within its district. The transaction has, in short, really amounted to a temporary shifting 
of banking funds from one district to another." 

' By this operation the bank gains in reserve money. It is given credit on the Gold Settle- 
ment Fund. See note • for description of the working of this fund. 

* By this operation the bank loses in reserve money. It is debited on the Gold Settlement 
Fund. See not« ' for description erf the working of this fund. 

* Figures are compiled from the yearly Reports of the Federal Reserve Board. 



THE WORKING OF THE REGIONAL SYSTEM 1 1 

Ratio of Total Reserves to Combined Net Deposit and Federal 
Reserve Note Liabilities, December 26, 1919 



Bank 


Actual 


After Adjustment of Reserves by Deducting 
Amount of Bills Rediscounted with or 
Sold to Other Federal Reserve Banks and 
Adding Amount of Bills Discounted for or 
Purchased from Other Federal Reserve 
Banks 


Boston 


44.0 
40.0 
40.8 

46.3 
40.9 
52.8 
50.6 
46.5 
39.4 
43-1 
49.4 
54-9 


24-3 
36.2 

327 
49-4 
43.5 
55.2 
58.8 
60.5 
39.4 
41-3 
77.0 
59.3 


New York 


Philadelphia 

Cleveland 


Richmond 


Atlanta 


Chicago 


St. Louis 


Minneapolis 

Kansas City 

Dallas 


San Francisco 


For all banks 


44.8 


44.8 



The amount of inter-district lending of funds has thus 
been great. But to what factors shall we ascribe the will- 
ingness of the various banks to cooperate in this way? 
Has it been due to the unusual circumstances of the period 
when operations of this sort were the greatest? Has it been 
merely an aspect of the problems of war and post-war 
finance? Or has it been the desire of the lending bank to 
establish a basis for its own pleas for aid when it itself 
should become the needy institution? Answers to such 
queries as these should throw some light upon the prob- 
able future amount of inter-district operations. 

Some explanation of the preceding problems is afforded 
by the following sentence from the Federal Reserve Bulletin 
for October i, 1920:' 

The process of shifting bank resources through inter-reserve 
rediscounting was necessarily called into play and has become 
a regular and important feature of the working of the Federal 
Reserve System. 

* Page 1014. 



12 FEDERAL RESERVE POLICY 

As to how this function of the reserve has developed, it 
will be recalled that in the earlier years under the reserve 
system the effectiveness of the machinery for transferring 
funds from district to district was not fully tested. The 
release of reserves on the inauguration of the reserve sys- 
tem and the inflow of gold from abroad in the following 
years made unnecessary the use of reserve funds to any 
appreciable extent. But after the period of rising prices 
during the war and the getting more completely into the 
market of the Federal Reserve, inter-district aid became 
necessary on the part of the district subjected to unusual 
crop-moving or seasonal demands. Since, however, the 
peak of money demand is not reached simultaneously in 
all districts, it is possible for the Reserve Board to offset 
the seasonable fluctuations and changes in demand against 
one another. In this way the strain previously thrown 
upon the city banks in the financial centers by the calls 
from the interior becomes merely a transfer of surplus 
reserve funds from one district to another. 

Various are the circumstances which determine the 
extent to which any one district bank may require such 
aid. Industries dependent largely upon agriculture must 
experience usually greater seasonal fluctuations in the 
demand for bank capital than those more largely manu- 
facturing. Districts covering a territory diversified in 
climate and in the nature of their industries may be able 
more easily to finance exceptional demands in one part by 
reliance upon surplus funds in another without drawing 
heavily upon other districts. A section thus diversified is 
Number 12, the Pacific Coast Section, including States 
from the Canadian border to the boundary line of Mexico. 

By relying upon the principle of reciprocity in the meet- 
ing of their mutual seasonal and emergency demands, it 
may be possible to avoid to some extent the objection of 



THE WORKING OF THE REGIONAL SYSTEM 13 

sectional financial isolation. It is true that the regional 
system creates some obstruction to the free flow of funds 
from district to district. Some friction will be encountered 
always in mobilizing effectively free bank funds. But this 
difficulty can be mitigated greatly and is perhaps justified 
by the adminrstrative efficiency and political advantage of 
the regional plan. 

One difficulty remains, however. If inter-district shift- 
ing of funds is regularly contemplated, wherein lies the 
advantage of the regional system in meeting objections 
emphasizing possibilities of sectional discrimination? 
Rediscounts by one reserve bank for another can be 
required by the Federal Reserve Board. According to the 
liberality with which it treats one district, and the con- 
servatism another, the display of sectional partiality is 
easily possible. If exercised, its results would be identical 
with the more direct partiality displayed by the director- 
ate of a single central bank. 

In the opinion of the writer, however, partiality in 
requiring reserve banks to render inter-district aid is not 
nearly so probable. Under the reserve system it will be 
expected that the borrowing districts in normal years shall 
not merely clear their books in the off season, but also 
shall be able to render aid to other districts in the slack 
season. In the long run the advances to member banks in 
any one district must bear some relation to the resources 
of the reserve bank, resources which represented originally 
the contributions of the members. Under a single bankers' 
bank the determination of the legitimate amount of 
advances to any one locality must be based on more hypo- 
thetical grounds. Failure to map out definite and per- 
manent districts would create much more difficulty in 
determining the relative merits of the demands of the 
various sections of the country. Under the present sys- 



14 FEDERAL RESERVE POLICY 

tern the resources of each reserve bank are real and the 
advances to any one section do not depend so largely upon 
the rulings of a single directorate. 

A query, of possibly greater importance, relating to the 
political expediency of the regional plan, necessitates some 
concluding discussion. How effective has been the regional 
plan in enabling the general administrative body — the 
Federal Reserve Board — to confine complaints to the 
district in which the discontent has arisen? To what 
extent has the Board been able to disclaim responsibility 
for policies initiated by the district directorate? In what 
measure has each district been held responsible by the 
public for conditions logically the result of its own poli- 
cies? Very important is the answer to this query because 
the system is much more likely to be modified by legis- 
lative action when complaints are directed against the 
central administrative body than when directed merely 
against one of the twelve administrative subdivisions. 

It must be admitted at the outset that there has been a 
persistent refusal by the general public to recognize the 
regional character of the system. In the period of agricul- 
tural depression following the spring of 1920, nothing was 
more clear than this. Newspapers and journals of the 
Middle West and South wrote many an editorial and pub- 
lished many a cartoon to establish the partiality of the 
Federal Reserve Board toward the metropolitan financial 
interests. In virtually all of these the existence of different 
reserve banks in the various sections of the country was 
ignored . * * The men who grew the wheat ' ' could not obtain 
credit to hold their crops for a fair price, whereas the "men 
who tried to corner the wheat market," it was asserted, 
were bountifully supplied with funds emanating from the 
Federal Reserve. No attention at all was ordinarily paid 
to the fact that the National City Bank of New York is 



THE WORKING OF THE REGIONAL SYSTEM 15 

served by the New York Reserve Bank; whereas the First 
National Bank of Waycross, Georgia, is served by the 
Atlanta Reserve Bank.^ 

Indicative further of this point of view, there is even to 
be found an address of the former Comptroller of the Cur- 
rency, and ex-officio member of the Federal Reserve 
Board, Mr. John Skelton Williams, delivered in Augusta, 
Georgia, July 14, 192 1.* The following extract may be 
quoted from this address : 

While small banks in the farming districts were being taxed 
in this manner, great banks in New York were being supplied 
with practically unlimited amounts of money at 5, 6, and 7 
per cent. The official record will show that while the Reserve 
Bank collected $2100 (equal to 8 per cent on the bank's entire 
capital stock for 12 months) from a little bank in your adjoining 
State of Alabama, for the use of about $112,000 for two weeks 
in crop-moving time, a year ago, a big bank in New York, 
whose funds were largely employed in speculative operations 
and deals, for the same cash consideration, or, say, $2100, was 
given the use of about $800,000 for the same time. 

And in his charges of wasteful and uneconomical expendi- 
tures before the Atlanta audience the bulk of the illustra- 
tions were drawn from the experience of the New York 
bank. The financial layman could easily gain the impres- 
sion that the Federal Reserve Board was a bank with its 
main office in New York City. 

In view of such assertions as these by a former member 
of the general administrative body, it is not at all surpris- 
ing that a large portion of the lay public has been induced 
easily to convict the Board of sectional partiality, even 

* It is indisputable that reserve funds found their way in large amounts in the 
post-war period to the speculative markets. But in the opinion of the writer 
this was an inevitable, though unintended result of the "easy-money policy" 
of the financial administration in the war and post-war period. This aspect 
of the problem will be discussed in later chapters. 

' This address is published in the Commercial and Financial Chronicle, July 23, 
192 1, pp. 354-58. 



i6 FEDERAL RESERVE POLICY 

though its regulations have been general and scarcely ever 
possessed merely a sectional application. 

Despite repeated assertions regarding the limitation of 
its own powers to points of general policy, the Federal 
Reserve Board has found it exceedingly difficult to define 
the sphere of regional responsibility. Attempts to estab- 
lish the accountability of the district directorate for its 
own specific acts have always occasioned severely adverse 
criticism. Indeed one of the legislators, possibly more 
responsible for the final form of the Reserve Act than any 
other one man, Senator Owen, complained on one occasion 
most bitterly ' that the Board's policy meant the abdica- 
tion of its powers. Thus : 

The Federal Reserve Board was created to control, regulate, 
and stabilize credit in the interest of all the people. . . . [It] is 
the most gigantic financial power in all the world. . . . Instead 
of using this great power as the Federal Reserve Act intended 
that it should be used, the Board abdicated. Instead of using 
this power In the interests of all the people, the bankers in- 
cluded, it delegated this power to the bankers.' 

As long as the act entrusts to the Board such general 
powers as supervision of rediscount rates; since decisions 
in such matters must always affect some districts more 
vitally than others, it will prove most difficult to place 
upon the shoulders of the district directorate any large 
measure of responsibility for what is believed to be the 
industrial and business results of its general credit policy. 
No matter how refined the game of ** passing the buck," 
success stands to be won by the body most frequently in 
contact with the public. The local banker, in denying 
credit accommodations lays responsibility upon the dis- 
trict directorate; the district board calls attention to the 
warnings of the Board against the granting of " unessen- 

^ Cf. Commercial and Financial Chronicle, July 30, 192 1, p. 475. 
''Six of the nine district directors are selected by the member banks. 



THE WORKING OF THE REGIONAL SYSTEM 17 

tial credits.** The Board, however, can find no body 
higher up, unless it be the legislators responsible for the 
terms of the statute. 

Nevertheless, the writer believes that the regional plan 
has many merits of political expediency. The reserve sys- 
tem is new, and much educational work still remains to be 
done in acquainting the public with the nature of its 
organization and operations. Because of the exceptionally 
abnormal period during which it has lived, it has been 
impossible for the Board to develop a permanent principle 
regulating reserve bank advances. 

Furthermore, the responsibility of the district director- 
ate has undoubtedly rendered it easier on many occasions 
for the Board to resist the directly expressed demands of 
certain special interests for credit advances. It has enabled 
the Board to insist that it itself was not a bank and had no 
money to loan. Thus Governor Harding was enabled to 
write Senator Smoot of Utah in the summer of 191 1 : ^ 

In view of the fact that the twelve Federal Reserve Banks 
are independent bodies corporate and are controlled and directed 
each by its own board of directors, subject only to the general 
supervision of the Federal Reserve Board, whose authority with 
respect to discount is confined principally to defining eligible 
paper in accordance with the terms of section 13 of the Federal 
Reserve Act, it seems to me that the statement which many, 
both in Congress and on the outside, urge be issued by the 
Federal Reserve Board, stating that the Federal Reserve Banks 
will adopt certain policies in connection with the rediscounting 
of agricultural paper, would have to be made by the Federal 
Reserve Banks themselves. The Federal Reserve Board has no 
power to interfere with the discretion given or the responsibility 
imposed by law upon the directors of a Federal Reserve Bank 
with respect to passing upon the merits of eligible paper offered 
for discount. 

^This letter, written July ii, 1921, is published in complete form, in the Fed- 
eral Reserve Bulletin, August, 192 1, pp. 895-99. 



I8 FEDERAL RESERVE POLICY 

Congress did not establish a central bank in this country. It 
established twelve banks under the general supervision of the 
Federal Reserve Board, which does not exercise hanking functions .^ 
These functions are exercised exclusively by the Federal Reserve 
Banks, 

We are now in a position to derive a general conclusion 
regarding the merits of the regional system. Politically it 
appears to the writer to have been a clever device. It has 
served to some extent in the past, and undoubtedly should 
serve to a greater extent in the future, to localize sectional 
complaints, and thus to ward off attacks which otherwise 
would be launched upon the reserve system as a whole. In 
an administrative way it has rendered possible an enor- 
mous increase in business with a minimum of friction. 
Had the plan of 1913 been that of a single central bank, it 
is by no means impossible that by administrative develop- 
ment it would have been organized finally upon lines some- 
what similar to those of the reserve system of to-day. 
Many duties can best be performed locally; district 
branches must be provided under any central banking 
system to assist in the work of check clearances, examina- 
tions of condition of member banks, analysis of the quality 
of paper of local origin offered for rediscount. Should such 
a system get into the market continuously, the work of 
these branches might not prove far different from that of 
the regional banks of to-day. 

The most vulnerable point of the regional system, in 
the mind of the writer, is the closeness of contact between 
the district directorates and the member banks. As indi- 
cated previously, this feature was dependent upon the 
desire to establish a group of bankers' banks which should 
exercise some measure of continuous control over the 
money market. The advantages of a smoothly working 

*The italics are the writer's. 



THE WORKING OF THE REGIONAL SYSTEM 19 

system of this sort are evident to all. But unless there are 
developed principles of credit control, more sound econom- 
ically than those enunciated in the past, the plan may 
prove to have been too ambitious. It might have been 
better to have proceeded upon the more modest lines of 
devising merely an emergency machine. But, as it is, the 
problem of the future is to develop sound rules for the 
regulation of the credit advances of a set of banks per- 
manently in the market. 



CHAPTER II 

CHECK COLLECTIONS AND CLEARANCES UNDER 
THE FEDERAL RESERVE 

The early treatment of the subject of check collections 
and clearances may evoke some surprise in the mind of the 
reader. In criticisms of the old banking system following 
the crisis of 1907, principal attention was not devoted to 
the country's clearance difficulties, and in most current 
discussions major emphasis has been placed upon the new 
system's discount functions. Nevertheless, the writer 
feels that the development of the Federal Reserve's par 
clearance system should be given a position of prominence. 

Prior to 191 4 clearing houses and clearing systems 
represented the most important institutions of coopera- 
tion developed through the initiative of the banks them- 
selves. But the work of these institutions was not the 
most efficiently coordinated and systematized. In par- 
ticular, the various sections of the country were not served 
by any single set of clearing institutions. What has been 
done under the Federal Reserve is to establish common 
centers for each of the districts under conditions whereby 
the work of each will be closely related. If we hold to the 
view that the reserve system was established primarily to 
secure more effective cooperation in banking, the impor- 
tance of the clearing functions of the new banks is clear. 

Check clearances, moreover, indicate more largely than 
any other single function the need of the continuous opera- 
tion of the reserve banks. The volume of rediscounting 
must alter greatly with changing business conditions; it 



CHECK COLLECTIONS AND CLEARANCES 21 

may be that on certain occasions there will be very little 
demand for the reserve system's funds. In the early years 
of operation, for instance, little success was achieved in 
the desire to get the reserve banks actively in the money 
market through their discount functions. Then, especially, 
was it highly important that a service be developed for 
which member banks would find a constant need. 

In no matter of government and administration, fur- 
thermore, has more tact and diplomacy been required 
than in the efforts to extend the scope of the reserve clear- 
ing system. In the early legislative history of the statute 
no provisions were more vehemently attacked than those 
providing for country- wide par collections. After the date 
of inauguration each step in the development of the clear- 
ing system has been carefully observed and analyzed by 
the great number of country banks. In view of the im- 
possibility of building an imposing reserve edifice upon 
the insufficient foundations of limited membership, this 
attitude of the country banks often compelled the modi- 
fications of plans which the requirements of efficiency 
would otherwise have dictated. 

Difficulties in check collections existing prior to 19 14 
are generally understood. In the first place, the indirect 
routing of distantly drawn checks created much delay in 
securing the return of checks to the drawee bank. As a 
second aspect of this difficulty reserves were built up in an 
exceedingly unscientific manner and consisted frequently 
to a large degree of checks in the mails. In the third place, 
check collections were rendered more expensive because 
the local clearing system usually comprised a portion only 
of the banks in the locality. It is a well-known principle of 
check clearances that the possibilities of offsetting clearing 
debits by clearing credits are limited when the system does 
not embrace a large portion of the banks which mutually 



22 FEDERAL RESERVE POLICY 

receive and collect each other's checks. One bank may 
receive in a day about the same volume of checks drawn 
against other banks as the other banks receive against it. 
But there is no guarantee that in a collection system of 
limited scope any one bank's credits may not greatly 
exceed its debits and vice versa. 

But to consider these difficulties more in detail, let us 
first turn our attention to the matter of the indirect routing 
of checks. The purpose of this prevailing custom was to 
enable some bank to avoid the deduction of exchange 
charges imposed by the drawee institution. Bank A, in 
one district, receives checks drawn against Bank B in 
another district. If A sends these checks directly to B, B 
would customarily remit something less than their full 
face value. Justification for this deduction was in part the 
clerical labor and other expense necessitated in the making 
of remittance. Bank B must remit by dispatching cur- 
rency by registered mail or express, or by drawing against 
a foreign balance previously established for this particular 
purpose. The building-up of these foreign accounts, be it 
by the purchase of exchange, the shipping of currency, or 
the discounting of its own note, was costly. Bank A in turn 
might attempt to recoup itself for this exchange deduction 
by imposing an exchange charge upon the individual who 
deposits the check. In many situations, however, banking 
customs were so firmly established and banking competi- 
tion so keen as to render impracticable such a practice in 
the case of regular clients. All the greater, consequently, 
was the necessity of avoiding if possible the loss through 
the deduction of exchange in Bank B's remittance. 

One of the means of escaping such a loss would be for 
Bank A to establish par relations with banks in foreign 
territory. Two banks located in different parts of the 
country could agree to collect for each other checks drawn 



CHECK COLLECTIONS AND CLEARANCES 23 

against banks in a certain prescribed territory.^ Thus 
Bank A gives full par credit to Bank C for the deposit of 
checks drawn against banks in the neighborhood of Bank 
A. Bank C does the same for Bank A. If Bank B is lo- 
cated in the district of Bank C, Bank A is able to collect 
through C without loss checks drawn against B. But in 
order to induce some outside bank to collect at par and 
thereby absorb the exchange charge, it was often necessary 
for one of the banks to maintain a deposit balance in the 
other. Thus: 

The First and Old Detroit National Bank carries deposits 
accounts in banks scattered over the country for the purpose of 
getting checks collected at par. In fact such checks are not 
collected at par, because the bank loses the use of its funds on 
deposit. The interest on such funds is the price paid for the 
"par" collections.' 

But the point most to be emphasized here is that the 
existence of such par points served to impede the direct 
return of checks. Instead of being sent directly to the 
drawee bank for remittance, they would be dispatched to 
the par or free city, where perhaps they would be again 
indirectly routed to the drawee bank. Bank A, for 
instance, dispatches checks drawn against Bank B not 
directly to B, but to its collection correspondent, Bank C. 

This devious routing increased the number of banks 
through which the "homing" check passed and padded 
the expenses of collection. But possibly more important 
than this increased expense was the manner in which such 
distantly drawn checks were customarily handled in the 
creation of legal reserves. By the practice previously per- 

* A good account of such arrangements is contained in an address by William 
J. Gray, at Portland, Michigan, August, 1916. This address was published in 
the Michigan Investor and quoted by the Commercicd and Financial Chronicle, 
August 19, 1916, pp. 636-37. 

^im. 



24 FEDERAL RESERVE POLICY 

mitted by the Comptroller of the Currency, the country 
bank remits a cash letter to the bank which acts as its 
collecting agent in the reserve city, "and on that day 
charges the amount of that cash letter to its reserve agent 
and considers it a cash balance and part of its reserve."^ 
Needless to remark, the reserve agent may find it impossi- 
ble to collect from the drawee bank for some days. It, in 
turn, may forward the check indirectly through one of its 
par correspondents and thereby create a reserve balance 
for itself. The same check may suffice finally to establish 
several fold its face value in reserve money before being 
charged to the account of the drawer. As a final outcome 
the check may retrace its path marked '*no funds." At 
one time it was estimated that the amount of checks in the 
mails — the so-called "float" — amounted to three hun- 
dred millions of dollars daily .^ 

The desirability of correcting such evils as these would 
appear to have furnished sufficient warrant for the altera- 
tion of former collection methods. But certain special 
circumstances, possibly less fundamental in their impor- 
tance, supplied in large measure the raison d'etre for the 
new machinery. Among these was the fact that under the 
reserve system it became necessary for the reserve banks 
to assume many functions previously provided for by the 
city correspondents of the country banks. There is no 
doubt but that in the discussion over banking reform 
victory was won by the "interior" as against the finan- 
cial interests in the metropolitan centers. In the panic of 
1907, interior banks found themselves unable to secure 
funds by drawing upon their New York deposits. This, 

^From an address by Benjamin Strong, Jr., delivered June 24, 1915, before 
the New York State Bankers' Association at Saratoga Springs, New York. A 
portion of this address is published in the Economic World, July 17,1915, pp. 
74-76. 

» Cf. E. W. Kemmerer, The A B C of the Federal Reserve System, pp. 20-21. 



CHECK COLLECTIONS AND CLEARANCES 25 

above all, explains, in the opinion of the writer, the willing- 
ness of the country banker to lend an ear to discussions of 
banking reform. Academic criticisms of the old methods 
were not nearly so determining. 

But what was the source of the 1907 difficulty in the 
financial centers? Was it not primarily this — bankers' 
balances were not invested properly, were not kept in 
sufficiently liquid form? Therefore must there be set up 
new institutions whose resources should be available for 
the members in time of need, institutions whose invest- 
ments must be kept liquid. The reserve banks were to 
become the city correspondents of country banks. But if 
the reserve banks were to function in this manner they 
must give credit for checks forwarded for collection by the 
member institutions. Otherwise the member banks would 
find the new machinery costly. To the foreign deposits 
established for purposes of collection must be added 
deposits the Reserve Act required to be kept with reserve 
banks. To avoid such duplication of deposits and, accord- 
ingly, of expense, the reserve banks, themselves, must act 
as collection agents. But if the credits, the reserves, of 
member banks were to be real and not hypothetical, the 
old method of establishing reserves must be modified. 
The "float" feature must be abolished. 

Banking reform, moreover, was not solely the result of 
criticism by bankers. It was to a very great degree the 
result of the demands of business which had been insisting 
for years that exchange exactions were unduly burdensome. 

It has been stated previously that, in their eagerness 
to secure deposits of country banks, city institutions 
were often willing to absorb exchange charges by giving 
immediate and full credit for the deposit of country bank 
checks. Often no attempt was made to recover this loss 
from the public. Nevertheless, the amount of exchange 



26 FEDERAL RESERVE POLICY 

charges paid by the public aggregated an enormous sum 
and there was an insistent demand that by the establish- 
ment of more efficient methods of check collections the 
burden borne by the public should be lightened. 

These exchange exactions, moreover, were not always 
imposed equitably, a feature which served to increase the 
public discontent. In Baltimore,' for instance, there was 
an old rule of the Clearing House that out-of-town items 
would be taken at par only from depositors who had been 
regular customers of their banks at the time, years ago, 
when a new rule was adopted requiring such charges of 
new depositors. But if an old customer should change his 
account to another bank, he was considered as a "new 
account" and lost his privilege of depositing at par. 
Change from one bank to another was not free. New cor- 
porations and new enterprises explained their hesitancy 
to establish themselves in this city on the ground that they 
would be handicapped in their competition with the older 
firms. In one case the par-deposit privilege was lost merely 
by a change in the firm name. The new name compelled 
the application of the rule applying to new businesses. 
Amid such conditions as these there was a widespread 
demand that the reserve system provide for the limitation 
of such exchange exactions. 

In the earlier legislative stages of the Federal Reserve 
Act provisions were inserted the intent of which was to 
eliminate these charges entirely. But the bill thus framed 
met speedy and vigorous objection on the part of a great 
majority of the exchange-charging banks. Many country 
banks asserted that the elimination of such charges would 
impair very seriously their profits. Nor would they accept 
the argument that in the course of time their interest 

^ Cf . weekly circular of Nelson, Cook & Co., of Baltimore, issued August 5, 
19 1 6. References to this circular are to be found in the Commercial and FinaiP- 
cial Chronicle, August 12, 1916, p. 534. 



CHECK COLLECTIONS AND CLEARANCES 27 

charges automatically would be increased to compensate 
for such loss; that since the competition between banks 
must determine the rates on bank loans, equal treatment 
to all could mean no discrimination against any one in par- 
ticular. Country banks maintained that in many situa- 
tions local competition was not operative in large degree; 
that custom and law were frequently so determinative as 
to prevent the shifting of such loss to the borrowing pub- 
lic. All banking communities, furthermore, display some 
rivalry one with another. The time has passed when 
banking custom can decree uniformly that a local indus- 
try shall depend exclusively upon the local bank. Elimina- 
tion of such charges would handicap most those institu- 
tions which in the past had depended upon exchange for a 
considerable portion of their profits. By the proposed new 
law the city institutions would often gain more than they 
would lose. In the past many of them had been willing to 
absorb such charges for the privileges of receiving the 
accounts of the country banks. It was often forgotten that 
under the Reserve Act these city institutions stood to lose 
a large portion of bankers' deposits through the transfer of 
reserves to the reserve banks. It was accordingly asserted 
that the elimination of exchange charges must affect most 
injuriously those banking institutions which previously 
had experienced the greatest difficulties in realizing reason- 
able profits. 

The collective legislative influence of the country 
bankers was enormous. Not merely did their number 
enable them to bring pressure to bear upon very many 
legislators, but it was peculiarly essential that the provi- 
sions of the act be not such as to cause the refusal of any 
large number of eligible banking institutions to join the 
system. It is not difficult, then, to account for the altera- 
tion in the terms of the bill according to which it was 



28 FEDERAL RESERVE POLICY 

expressly stipulated that nothing in the act should be so 
construed as to prohibit a member bank from charging its 
actual expenses incurred in collecting and remitting funds, 
or for exchange sold its patrons. 

We may now summarize the various provisions of the 
act as finally enacted dealing with check collections and 
clearances. First, there was the provision of section i6 
that 

Every Federal reserve bank shall receive on deposit at par 
from member banks or from Federal reserve banks checks and 
drafts drawn upon any of its depositors, and when remitted by 
a Federal reserve bank, checks and drafts drawn by any depos- 
itor in any other Federal reserve bank or member bank upon 
funds to the credit of said depositor in said reserve bank or 
member bank.' 

This provision is made subject to the exception noted 
above. Since a Federal Reserve Bank is thus required to 
give credit to other banks, economy and efficiency would 
demand that it clear the checks thus received, in order to 
employ the most economical method of determining the 
net credit or debit balance due from or to any bank. 
Accordingly there was enacted the further provision in the 
same section that the Federal Reserve Board 

may also require each such [reserve] bank to exercise the func- 
tions of a clearing house for its member banks. 

This last-quoted provision would concern intra-district 
clearings. But the receipt by one reserve bank of checks 
drawn against member banks in other districts would 
create debits and credits among the various reserve banks. 
Bank A of district one receives credit for a check drawn 
against Bank B of district two. The reserve bank of dis- 
trict one recoups itself by charging to the reserve bank of 
district two. In similar fashion the reserve bank of district 

* A similar provision was contained in the first paragraph of section 13. 



CHECK COLLECTIONS AND CLEARANCES 29 

three receives items collectible in district two and vice 
versa. Accordingly another sentence of section 16 gives 
the Federal Reserve Board discretionary power to 

exercise the functions of a clearing house for such Federal re- 
serve banks. 

This, as noted in Chapter I, made necessary the later 
establishment of the Gold Settlement Fund at Washington. 

From the wording of the act, it would appear as if the 
exchange-charging banks had won a complete victory. 
The law provided that the reserve banks ''shall" receive 
at par checks drawn on member banks. It furthermore 
reserved expressly the right to the drawee bank to deduct 
reasonable exchange for expenses incurred in collecting 
and remitting funds. Must not the reserve banks be 
obliged, therefore, to absorb the costs of collecting checks? 

Means of escaping the absorption of such charges would 
seem to lie, therefore, in the following lines of action: 
First, the " shall " in the clause of section 16 above referred 
to might be construed as permissive and not mandatory.' 
Such a construction, however, was unlikely, as it would 
involve a perversion of the meaning usually understood to 
pertain to the word "shall." Second, the reserve bank 
might agree to bear the expense of remittance of funds 
from member to reserve banks, . and thus, by eliminating 
this item of expense, destroy, partially at least, the right 
of the drawee bank to charge exchange. If necessary 
checks could be presented at the counter and their full 
face value demanded. In the third place, the permissive 
"may" of the last paragraph of section 16, relating to the 
clearing functions of reserve banks, might be so construed 
as to deny membership in the clearing system to those 
member banks which insisted on deducting exchange. In 

^ Some slight confirmation of this view is aflforded by the fact that the similar 
provision of section 13 contained the permissive "may." 



30 FEDERAL RESERVE POLICY 

other words, the permissive "may" might enable reserve 
banks to refuse to clear for banks which would not agree 
to whatever conditions should be imposed upon clearing 
members. One of these conditions might be the agreement 
of a member bank to remit at par. The final outcome of 
the clearance problem must depend much upon future 
statutory interpretation and administrative procedure. 

Because the work of the reserve banks must be built up 
anew on bed-rock foundations, it was not to be expected 
that the reserve banks, immediately in 19 14, should begin 
the exercise of all the functions contemplated for ultimate 
development. Neither was it expected that the various 
reserve banks should all operate at the outset in precisely 
the same manner. Beginnings were slow and varied much 
between the various district banks. In the early days the 
New York Reserve Bank, for instance, would receive 
checks drawn only on reserve banks and those drawn by 
a member bank on another member institution in the 
cities of New York, Albany, and Brooklyn.^ On December 
I, 1914, the Federal Reserve Board granted the reserve 
bank of Kansas City power to clear checks presented by 
member banks drawn on member banks.^ St. Louis was 
also among the first to provide such service and on the 4th 
of March, 19 15, it was announced by the Board that the 
Chicago Federal Reserve Bank had been clearing checks 
between the member banks of the seven Reserve and Cen- 
tral Reserve cities of the district.^ But on the same date it 
was announced that only three reserve banks, those of 
Kansas City, St. Louis, and Chicago, had taken advan- 
tage of the clearance privileges conferred by the act. 

^ Cf . letter by Governor Strong, of the New York Reserve Bank, in the Com- 
mercial and Financial Chronicle, December 5, 1914, p. 1636. 
» Cf. Commercial and Financial Chronicle, December 5, 1914, p. 1635. 
3Cf. ibid., March 13, 1915, p. 867. 



CHECK COLLECTIONS AND CLEARANCES 31 

Aside from the initial pressure of new work and duties 
there were additional reasons for delay. Inter-district 
clearings awaited the development of the Gold Settlement 
Fund, an undertaking not successfully completed until 
June, 1915.^ Intra-district clearings uncovered some legal 
objections, 

it being argued that there is no power to compel a member bank 
not located in a Federal Reserve city to pay or have charged to 
its account at the Federal Reserve Bank of its district a check 
which it had not seen and approved prior to the times of presen- 
tation at its own counter.^ 

There was also a natural hesitancy to establish a clearing 
system, which, on the one hand, might admit the right 
of the drawee bank to charge exchange, or, on the other 
hand, to create early opposition to the system by definitely 
eliminating such charges. Furthermore, because final 
transfer of reserves to reserve banks was not to be com- 
pleted for three years, financial considerations created 
some solid basis for opposition to the immediate introduc- 
tion of a complete clearance system which might neces- 
sitate the maintenance of balances with reserve banks. 
During the period in which reserves could be kept par- 
tially with city institutions, it might be a hardship to com- 
pel city banks to give up this clearance work to the reserve 
or to compel country banks to transfer balances to the 
reserve institutions for clearing work. Balances with the 
reserve banks would draw no interest. For these various 
reasons the Reserve Board began to work first on the 
establishment of a voluntary-reciprocal plan of clearances. 
It was believed that sufficient success might be achieved 
with such a system to render unnecessary measures ultra- 
compulsory in nature. 

* Cf. Report of the Federal Reserve Board for the year 1915, p. 14. 
'Ikid., p. 15. 



32 FEDERAL RESERVE POLICY 

In the spring of 19 15 the Federal Reserve Board began 
to send to the various reserve banks descriptive circulars 
of the new voluntary -reciprocal plan.^ According to this 
plan membership was to be purely voluntary. Checks 
would not be cleared drawn upon banks which would not 
agree to remit at par. But, on the other hand, banks not 
agreeing to remit the full face value of checks drawn 
against them could not avail themselves of the facilities 
of the reserve system in collecting checks drawn upon 
other banks. Details of operation would differ in the vari- 
ous districts. In the Chicago district,^ the costs of operat- 
ing the system were to be borne by the reserve bank and 
each bank must maintain sufficient funds on deposit with 
the reserve bank to permit the immediate charge of debit 
balances. The amount of such balances would be deter- 
mined by experience gained as the system continued its 
operation. But regardless of the details, the clearing sys- 
tem in each district was to be open to every bank which 
would agree to permit the deduction at par of its own debit 
items. The motives for joining the system would be: first, 
the economies realizable in the collection of checks drawn 
against other banks; second, increased acceptability of 
the member's own checks. 

In the opinion of the great majority of the banks, how- 
ever, either the time for entrance was inopportune, or the 
obligations greatly outweighed the privileges. By Janu- 
ary, 19 1 6, it was stated^ that only about twenty-six hun- 
dred out of a total number of eight thousand member 
institutions had subscribed to the provisions necessary 
for admittance. Accordingly, the Board felt that more 
compulsory measures were necessary. As a consequence 
of this belief there was devised a new system which began 

* Cf. Bulletin, May i, 1915, pp. 6-7. ' Cf. ibid., pp. 7-9. 

3 Cf. Commercial and Financial Chronicle, January I, 1916, p. 15. 



CHECK COLLECTIONS AND CLEARANCES 33 

operation on July 15, 19 16. This plan provided the nucleus 
for the development of the present clearance system. 

By the terms of this new plan, member banks, regard- 
less of their own volition, were to be required to pay with- 
out deduction checks drawn upon themselves and pre- 
sented at their own counters. Remittance by the reserve 
banks through the mail was to be construed as presenta- 
tion at their own counters. Settlement could be made by 
acceptable checks on other banks or by the shipment of 
lawful money or Federal Reserve notes ^ at the expense of 
the reserve bank. It would not be necessary, therefore, for 
banks to maintain balances at reserve banks for clearing 
purposes. For its services as a collection agent the reserve 
bank could collect a small service charge of, say, one and a 
half to two cents an item from the bank for whom collec- 
tions were made. In the course of time, however, such 
charges were eliminated. 

The only compulsory feature of the new plan was that 
requiring payment at par from drawee member banks. 
Member banks were free to keep clearing balances else- 
where and to clear through private agencies if they so 
desired. But it was not believed that many member banks 
would find it to their advantage to clear elsewhere than 
through the reserve. If they must remit at par to the 
reserve banks, why not gain the advantages of collection 
of credit items at par? By construing the sending of checks 
through the mails as presentment at the counter, it was 
believed that legal objection could not be made to the 
denial of the right of a bank to deduct exchange. 

Under the new system checks would also be received 
drawn upon such non-member institutions as could be 
collected at par. Desire to avail of the economies in the 
collection of credit items and to increase the circulatory 

» See Bulletin, June i, 1916, pp. 262-64. 



34 FEDERAL RESERVE POLICY 

power of their own checks might be appealing motives 
influencing non-member institutions to remit at par. To 
make the law more clear regarding the status of non- 
member banks, an amendment was secured to the Federal 
Reserve Act on September 7, 19 16, expressly permitting 
reserve banks to receive deposits of all checks and drafts 
payable upon presentation. 

This amendment, however, contained no mandatory 
provision regarding the remittances of State banks. Re- 
fusal of any large number of such banks to become clearing 
members must weaken the system seriously. The services 
rendered by the reserve banks must depend upon the 
volume of checks collectible for each clearing member. 
Consequently, some of the reserve banks began to search 
for various means of compelling membership. The meas- 
ures adopted were often expensive, but were undertaken, 
nevertheless, on the theory that if, by presentation at the 
counter, the State banks could be forced to make par 
remittance, they would perceive the desirability of joining 
the reserve clearance system and thereby gain whatever 
advantages this system offered as an agency for the col- 
lection of their own credit items. 

Collection at the counter necessitated local agencies to 
protest items not promptly paid. In case a member bank 
was located in the town, there would be no great difficulty 
in establishing such an agency. Otherwise arrangements 
must be made to secure the services of some other institu- 
tion. At one time a project was developed whereby post- 
masters might act as agents of the reserve banks in towns 
where no member bank was situated.^ But undoubtedly 
because of its doubtful political expediency this project 
was abandoned. Often notaries and express agents would 
be employed. In some cases it is asserted that the reserve 

* Cf. Commerciai and Financial Chronicle, July 22, 1916, p. 284. 



CHECK COLLECTIONS AND CLEARANCES 35 

bank or its agent would save up the checks of the State 
bank until they amounted to a considerable volume. Then 
they would be dispatched to the drawee bank by automo- 
bile or otherwise and presented in bulk. 

Such arrangements were pushed zealously and possibly 
in some cases with excessive vigor. In an address delivered 
in the House, Representative Reavis complained on one 
occasion that in the town of Pierce, Nebraska, representa- 
tives of the reserve bank saved up checks until they 
amounted to ?4 1,000.^ Then they went in an automobile 
to this town and demanded payment in cash. Inasmuch 
as every bank bases its operations on an approximate 
daily correspondence of daily income and daily outgo, such 
measures must prove exceedingly embarrassing. Repre- 
sentative Reavis also charged that in its endeavor to force 
this bank to terms the reserve bank had a man on the 
ground endeavoring to organize a competing national bank. 

These attempts at coercion inevitably occasioned the 
utmost of protest by the non-member State banks. Their 
protests were expressed in various ways. Bankers' asso- 
ciations were exhorted to exert pressure in their behalf, 
and efforts were made to secure the enactment of legisla- 
tion prohibiting the coercive measures. In suits at law, 
moreover, the reserve banks were accused of exceeding 
their lawful powers. 

As an outcome of such protests laws were enacted in 
several States unfriendly to the Board's plans. Among 
these States were North Carolina, Tennessee, and Missis- 
sippi. As a type of such legislation the Mississippi law is 
well worth summarizing.^ First, it definitely legalized what 
it called "the established custom" of banks of that State 

^ Extracts from this address are published in the Commercial and Financial 
Chronicle, February 7, 1920, pp. 515-16. 
' The complete text of this law may be found in the Bulletin, April, 1920, p. 387. 



36 FEDERAL RESERVE POLICY 

to charge a service fee commonly called exchange for col- 
lection and remittance. Second, banks were given discre* 
tionary power to deduct exchange on items presented by 
any bank, "post-office, express company, or any collection 
agency, or by any other agency whatsoever." In the third 
place. State officers were deprived of power to "protest 
for nonpayment any such 'cash item' when such non- 
payment is solely on account of the failure of any of such 
agencies to pay such exchange." Furthermore, there 
should be "no right of action, either at law or in equity, 
against any bank in this State for refusal to pay such cash 
item, when such refusal is based alone on the ground of the 
nonpayment of such exchange." 

Various suits at law were begun also to test the validity 
of the coercive measures. The most important of these was 
the American Bank and Trust Company et al. v. Federal 
Reserve Bank of Atlanta. On appeal this suit was brought 
to the Supreme Court of the United States.' In this case 
it was alleged that the practice of the Atlanta Reserve 
Bank had been to accumulate a large number of checks 
upon the exchange-charging banks, then present them at 
the counter, and demand cash in payment. It was com- 
plained that such methods were employed with malicious 
intent, for the purpose of injuring the business of the non- 
member drawee banks. In the decision of the district 
court it was held that the defendant's right to cash checks 
in this way was absolute, and that the matter of malicious 
intent was irrelevant. This ruling, however, was reversed 
in the decision of the higher court. Consequently the case 
was remanded to the original court for decision upon its 
merits. 

Because of its probable future importance, certain 

* The opinion delivered by Mr. Justice Holmes is printed in the Bulletin, 
June, 192 1, pp. 700-01. 



CHECK COLLECTIONS AND CLEARANCES 37 

remarks of Mr. Justice Holmes, who delivered the opinion 
for the Supreme Court, are well worth quoting. Thus : 

The defendants say that the holder of a check has a right to 
present it to the bank upon which it was drawn for payment 
over the counter, and that however many checks he may hold 
he has the same right as to all of them and may present them all 
at once, whatever his motive or intent. . . . But the word 
"right" is one of the most deceptive of pitfalls; it is so easy to 
slip from a qualified meaning in the premise to an unquaHfied 
one in the conclusion. Most rights are qualified. 

And then, after a few illustrations of the necessity of 
guarding carefully our concept of "rights": 

Banks, as we know them, could not exist if they could not 
rely upon averages and lend a large part of the money that they 
receive from their depositors on the assumption that not more 
than a certain fraction of it will be demanded on any one day. 
If without a word of falsehood, but acting from what we have 
called disinterested malevolence, a man by persuasion should 
organize and carry into effect a run upon a bank and ruin it, we 
can not doubt that an action would lie. 

To determine the lawful procedure for the defendants (the 
reserve bank) 

it is not enough to refer to the general right of a holder of checks 
to present them, but it is necessary to consider whether the 
collection of checks and presenting them in a body for the pur- 
pose of breaking down the petitioner's business as now con- 
ducted is justified by the ulterior purpose in view. 

The probable results of this decision were variously 
interpreted. Many exchange-charging banks hailed it as 
the legal solution of their difficulties, and predicted as the 
final outcome the withdrawal of many non-member banks 
from the par list and the final acknowledgment by the 
reserve institutions of the drawee bank's right to deduct 
exchange. In this vein writes Mr. L. R. Adams,' in the 
Journal of the American Bankers' Association:^ 

^ Mr. Adams was secretary-treasurer of the Country Bankers' Association 
of Georgia. » Issue of June, 192 1, pp. 776-79. 



38 FEDERAL RESERVE POLICY 

We anticipate that the final effect of the Supreme Court's 
decision will be that both member and non-member banks will 
be given the right to charge reasonable exchange on checks 
cleared through the Federal reser\^e system or otherwise. How- 
ever that may be, it appears that the country banks of Georgia 
. . . have laid out a road which the Supreme Court has paved 
with concrete principles of justice, over which the non-member 
banks may safely and smoothly travel, using as a vehicle the 
equity processes of the Federal courts, to a safe haven in which 
they may exercise their lawful functions without fear of "embar- 
rassing, annoying and expensive" methods of forcing their com- 
pliance with unauthorized demands. 

When the case was remanded to the lower court, how- 
ever, for a decision on its merits, the opinion of the court 
was hostile to the plaintiffs. United States District Judge 
Beverly D. Evans held^ that the reserve banks properly 
could collect all checks payable upon presentation, includ- 
ing checks drawn on non-member banks, and that they 
could not pay any exchange charges. As regards the 
method of collection the court stated : 

(3) In the discharge of its duties with respect to the collection 
of checks deposited with them, and with respect to performing 
the functions of a clearing house, the several Federal reserve 
banks are empowered to adopt any reasonable measure designed 
to accomplish these purposes. To that end a Federal reserve 
bank may send checks to the drawee bank directly, for remit- 
tance through the mails, of collections without cost of exchange. 
If the drawee bank refuses to remit without deduction of the 
cost of exchange, it is in the power of the several Federal reserve 
banks to employ any proper instrumentality or agency to col- 
lect the checks from the drawee bank, and it may legitimately 
pay the necessary cost of this service. 

(4) The process of the daily collection of checks, in the exer- 
cise of the clearing-house functions, is not rendered unlawful 

' This opinion is printed in the April, 1922, Bulletin, p. 436. 



CHECK COLLECTIONS AND CLEARANCES 39 

because of the fact that of the checks handled two or more of 
them may be drawn on the same bank. 

Only in one respect did this opinion grant comfort to 
the complaining banks. It was held that there should not 
be publication on the par list of the name of a non-member 
bank without its consent. While it might be true that the 
checks of a certain non -member bank could be collected 
at par, it might also be that this bank had not consented to 
the par clearance plan. But this is a matter of minor 
importance. 

But before the opinion of Judge Evans was announced 
it did not appear to the writer that the enthusiastic predic- 
tions of Mr. Adams could be fulfilled. It would seem as if 
always the burden of proof regarding the matter of mali- 
cious intent would rest on the complainants. Furthermore, 
courts, very likely, will be inclined to be liberal in inter- 
preting the collection difficulties of the reserve banks. It 
cannot be expected that the reserve bank shall submit to 
unnecessary expense in the collection of a single check. 
Economy will justify their collection in batches. To 
determine when malicious motives are present will require 
special evidence in every case. The expense of such litiga- 
tion may operate to deter many of the small country 
banks from bringing suit.' Finally, not everything in the 
opinion of Justice Holmes was favorable to the contention 
of the plaintiffs. For one matter, it was held that in a 
case of this sort the Federal and not the State courts 
possessed jurisdiction. If it be true that the general body 
of business opinion is hostile to the exchange charges,, re- 
serve banks may prefer to have such cases decided in the 
United States courts, which are more likely to be in- 
fluenced by the general attitude of the country as a whole 
and not that of a single community. 

^ Of course attempts may be made to distribute this expense through the for- 
mation of associations of bankers. 



40 FEDERAL RESERVE POLICY 

If this conclusion be correct, relief for the exchange- 
charging banks can be had only by securing changes in the 
Federal statute. As a matter of previous development 
such statutory alterations already had been vigorously 
attempted. At first only success was achieved. In the 
spring of 19 1 7 the so-called Hard wick amendment to the 
Federal Reserve Act was passed in the Senate expressly 
legalizing the deduction by the drawee bank of a reason- 
able charge for the collection and remittance expenses, and 
in the House, on May 10, 1917, by a vote of more than two 
to one, conferees were directed to accept the substance of 
this amendment. Before the conferees came to an agree- 
ment, however, it was charged that intensive lobbying was 
employed in order to defeat the amendment. Regarding 
this Mr. Thralls states: ' 

A nation-wide campaign had been conducted by the Credit 
Men's Association, the mail-order houses, manufacturers, 
jobbers, wholesalers, and merchants in the large centers for the 
defeat of the Hard wick amendment. These interests were ably 
assisted by the Federal Reserve Banks. 

Material changes, which if literally interpreted will defeat the 
purpose of the amendment, were made in conference. When 
the bill was reported for consideration in the House, the point of 
order that the managers of the House had not obeyed instruc- 
tions was overruled. This ruling, in the minds of many, is con- 
trary to parliamentary precedents. The Administration pres- 
sure was turned on, and the report was accepted. It contained 
two modifications: 

1. Providing that the charges are to be determined and regu- 
lated by the Federal Reserve Board. 

2. Providing that no such charges shall be made against the 
Federal Reserve banks. 

This last modification, when it became law, took the 

I Cf . Mr. Jerome Thralls, secretary of the National Bank and Clearing House 
Sections of the American Bankers' Association, in the Journal of the American 
Bankers' Association for July, 19 17. The substance of this address is printed in 
the Commercial and Fina?icial Chronicle, July 21, 1917, pp. 235-36. 



CHECK COLLECTIONS AND CLEARANCES 41 

teeth out of the amendment. It completely turned the 
tables on the exchange-charging banks. So far as the law 
was altered at all, it affirmed more definitely than ever the 
right of the reserve banks to refuse exchange deductions 
by drawee banks. 

Mr. Thralls's charge that the Hardwick amendment was 
unfairly defeated may be true. But aside from the means 
employed, the Federal Reserve Board had an exceedingly 
strong case. In the first place, expense of remittance to the 
collection agent was reduced by the agreement of the 
reserve bank to absorb such costs on checks cleared 
through it. A part of the justification for the earlier prac- 
tice was thus eliminated. In the second place, the pro- 
hibited charges related only to those sought against the 
reserve banks and did not apply to those levied upon the 
public. In view of the economies of collecting through 
an efficient clearing system, such levies, however, should 
be much more reasonable than those exacted under the 
old banking system. Banks would no longer be obliged 
to maintain deposits in outside private banks in order to 
facilitate the collection of their own checks. If the reserve 
banks give credit at par, should they not be permitted to 
collect at par? If the reserve banks are considered as act- 
ing merely as an agent for the member banks, elimination 
of exchange charges could not affect them at all in the 
aggregate. To the extent that one bank is denied an item 
of income, another is saved an item of expense. 

It will always be extremely difficult to ascertain the real 
attitude of the banks toward the Board's clearance plan. 
Many bankers who disliked this feature of reserve opera- 
tion may have withheld vigorous objection because of 
their dependence upon other functions of the Federal 
Reserve. On the other hand, some of the larger city banks 
may have felt it impracticable to take a leading part in the 



42 FEDERAL RESERVE POLICY 

agitation for the spread of the plan for fear of estranging 
the country banks for whom they wished to continue to 
serve as city agents. In point of numbers, however, it is 
undoubtedly true that the decision of the bankers would 
be decidedly unfriendly. At least, the results of most 
referenda indicate general hostility toward the plan. In 
one such referendum, conducted by Mr. Jerome Thralls, 
of the Clearing House and National Banks Sections of the 
American Bankers' Association, more than three fourths 
of the replies gave a negative answer to the following ques- 
tion: "Is the plan of clearing and check collection now 
operated by the Federal Reserve banks satisfactory to 
you?"' On another occasion Governor Harding, of the 
Federal Reserve Board, admitted that probably twenty 
thousand out of twenty-four thousand acquiescing banks 
had agreed to the system unwillingly.^ Mr. Harding justi- 
fied the plan on the ground that it represented solely the 
sincere desire to administer the law. If relief was desired, 
he insisted that pressure should be brought to bear upon 
the legislative branch of the Government and not upon the 
Federal Reserve Board. Stating further that the Board 
desired to clear up any possible vagueness as to the intent 
of the legislators, he even suggested the terms of a possible 
amendment to the law which would preserve the right of 
exchange deductions.^ This attitude of Mr. Harding, 
however, can be reconciled only with difficulty with his 
policy at the time of legislative consideration of the Hard- 
wick amendment. Then he took an active, and not merely 
passive, position of hostility to the terms of the amendment 
suggested by the exchange-charging banks. 

Aside, however, from the popularity of the par collec- 
tion system the Board has met with remarkable success in 

^ See Commercial and Financial Chronicle, December i6, 1916, p. 2199. 

» Cf. ihid., May 15, 1920, pp. 2034-36. 

3 See Commercial and Financial Chronicle, May 15, 1920, pp. 2036-37. 



CHECK COLLECTIONS AND CLEARANCES 43 

its endeavors to extend the scope of the new plan. It is 
true that at first much difficulty was encountered. In the 
Federal Reserve Bulletin for February i, 19 18, we read : ^ 

Where good progress has been made it has been almost invar- 
iably due to energetic solicitation by one or more members of 
the staff of the bank who have devoted their attention to the 
matter and have done actual work for the purpose of adding to 
their par list. 

Nevertheless, on February 15, 1922, 28,906 member and 
non-member institutions were on the par list and only 
2,327 not on this list. On this date every bank in the Bos- 
ton, New York, Philadelphia, Chicago, and San Francisco 
districts was a member of the clearing system. The vol- 
ume of work accomplished has increased enormously. In 
the month January 16 to February 15, 1922, total items 
handled amounted to nearly eleven billions of dollars. 

It has been suggested previously that the attitude of 
business in its desire to avoid exchange charges has been 
the principal support of the reserve banks in the employ- 
ment of their coercive measures. Undoubtedly much of 
the approval of business in the early days was due to the 
mistaken belief that as a final outcome all exchange 
charges would be absolutely eliminated. As previously 
indicated, this is not true. There is now legal warrant for 
the exaction from the public of certain minimum charges. 
While on the whole such charges are less than in the old 
days, there are numerous exceptions due to the desire of 
many banks to make up in charges to the public what has 
been lost in exactions against other banks. Thus the 
Farmers & Merchants National Bank of Los Angeles, 
California, stated in its monthly letter on September 15, 
1916:=' 

» Page 75. 

' Extracts from this letter are printed in the Commercial and Financial Chron- 
icle, September 23, 19 16, pp. 1083-84. 



44 FEDERAL RESERVE POLICY 

The banks on the Pacific Coast, for instance, have heretofore 
accepted Eastern drafts at par. They recoup themselves by 
seUing exchanges against Eastern funds thus obtained. To-day, 
if a man walks into a Pacific Coast bank with a draft drawn by 
a solvent party on an Eastern bank, and wants immediate 
credit for the proceeds thereof, he will be compelled to pay for 
the use of the money until the bank cashing the draft has re- 
ceived its proceeds from the party upon whom it is drawn. If a 
merchant deposits out-of-town items and gets immediate credit 
for them, he will be compelled to pay the bank with whom he 
makes the deposit for the use of the money advanced on those 
items until the bank has collected them. There are a thousand 
and one services which banks have gratuitously performed for 
their customers that they will now charge for. 

It will be generally agreed that such practices, if not 
carried to undue lengths, are as they should be. Nobody 
will argue that the bank should perform such services 
gratis. Losses encountered in one operation must be made 
up in others. What has been accomplished under the 
Federal Reserve has been to place the various services of a 
bank on such a basis as to increase the likelihood that each 
will carry a larger portion of its own cost. As previously 
indicated, the aggregate burden borne by the public 
should be considerably reduced under the new plan. No 
longer need so many deposits be maintained at various 
points throughout the country for domestic exchange pur- 
poses. No longer need checks be indirectly routed with 
resulting increases in clerical and postage expense. No 
longer is the principal clearance work of the country per- 
formed entirely by unrelated and uncoordinated clearing 
organizations. These economies should redound ultimately 
to the benefit of the public. 

In order that the reserve banks should function satis- 
factorily as the correspondent banks of the members, it 
soon became necessary that they handle other items than 
bank checks. It would have worked a hardship to require 



CHECK COLLECTIONS AND CLEARANCES 45 

member banks to maintain balances with city correspond- 
ents in addition to those with reserve banks. Accordingly 
in the Bulletin for September i, 19 17,' we read that the 
Board requests the various reserve banks to establish 
collection departments for time items. At the present 
time the reserve system handles, in cases where satisfac- 
tory arrangements exist for collecting checks, such items 
as promissory notes, trade bills, trade drafts, coupons and 
acceptances. This extension of the reserve activities was 
necessary if the reserve banks were to be effective substi- 
tutes for the former reserve agents of member banks. 

The growth in this collection work has necessitated a 
considerable enlargement of the functions of the Gold 
Settlement Fund. Prior to the development of the inter- 
district system it was employed largely to handle transfers 
or drawings between reserve banks. Later it became the 
means by which individual banks could be benefited 
directly. Transfers originating with one member bank 
can be made in the interest of another member bank of 
another district. In the course of its development it be- 
came the agency by which transfers could be made on note 
accounts between the Federal Reserve agents and the 
reserve banks which they represent. Finally it became 
the clearance fund for the inter-district collection system. 
It is impossible to stress too highly its functions in ena- 
bling to run smoothly the machinery of domestic exchange. 

What now shall be our conclusions regarding the merits 
of the par collections controversy? Shall we take the posi- 
tion that because of its economy and efficiency its further 
progress should not be impeded? Or should we conclude 
that, while an economy may have been wrought for the 
banks as a whole, it has discriminated unfairly against the 
small country bank? 

' Page 66i. 



46 FEDERAL RESERVE POLICY 

It is clear, first of all, that the law does not prevent the 
country bank from levying upon the depositor of a check 
drawn upon a foreign bank. Some banks, however, receive 
fewer checks drawn upon foreign banks than are presented 
to them for collection. Such charges may not be sufficient 
to overcome the loss due to the necessity of remitting for 
its own checks at par. If this be the situation, then, why 
not levy upon the depositor who sends a check to a distant 
point and thereby imposes upon the bank the burden of 
providing remittance? 

It is obvious that much friction would be created if any 
such per- item expense were imposed. The necessity of 
such a charge would not be understood generally, and 
banking has so developed that the depositor has come to 
feel it his innate right to emit checks drawn against his 
account to any distant point. As a matter of business 
policy the country bank cannot recoup in this manner. 
But there still remains the possibility of recouping in- 
directly. Cannot the depositor be required to maintain a 
larger average balance? If not this, cannot it be recog- 
nized that, since former collection profits are lost, the inter- 
est charge on the original loan must be permitted to adjust 
itself to a higher point? 

Much can be said in behalf of the method of requiring 
larger minimum balances. Many accounts are unprofit- 
able; should not the country as well as the city bank en- 
deavor to refrain from doing any portion of business at a 
distinct loss? The balance idea, moreover, would prove 
helpful in other connections, such as to render it more 
difficult to overdraw accounts, and to preserve for the 
bank funds the depositor does not require in his period of 
slack business.^ The only objections to such methods would 

' The balance idea tends to encourage a borrower to keep, in his slack season, 
as large balances as possible in order that the yearly average may be high. 



CHECK COLLECTIONS AND CLEARANCES 47 

be the difficulties of introducing new and unwelcome 
methods into a competitive situation where old customs 
have had time to harden. 

But are these objections sufficient to warrant the resto- 
ration of the old custom of permitting deductions against 
the foreign bank of deposit? Should the Federal Reserve 
Act be so amended as to permit reasonable charges to be 
levied against the collection agents of the banks of deposit, 
the reserve banks? 

Many difficulties to such a solution appear immediately. 
A charge against the reserve bank is an indirect charge 
against its member banks.^ Why should the reserve bank 
lessen the earnings available for the group in order that 
the drawee bank, which may not even be a member of the 
reserv^e system, may have its checks cleared without cost 
and possibly at a profit? Why should the bank, member 
or non-member, whose checks are distributed in largest 
volume in distant communities, derive extra commissions 
as against banks which have not created so much work 
and expense for outside collection agencies? Is not the 
reserve bank already rendering in direct as well as indirect 
ways, a sufficiency of free services for the non -member 
banks of the country? Will not the proper regulation of 
the reserve system prove all the more difficult if the twelve 
reserve banks are put under added pressure to earn at all 
times sufficient to offset these and similar costs? 

Answers to these queries are not promising: With the 
change in old methods, the substitution of reserve banks 
for independent private banks as reserve agents, there is 
nolonger the same justification for the imposition of large 
charges against the collecting bank. The solution for the 
country exchange-charging bank must be found in re- 

* The member banks are the stockholders of the reserve banks. Of course, the 
burden would be borne by the Government if the earnings were more than 
sufficient to meet the minimum amount permitted for stockliolders. 



48 FEDERAL RESERVE POLICY 

couping from the depositors of foreign items, by direct 
exchange charges imposed upon the public, by requesting 
offsetting balances from customers who demand the right 
to circulate checks outside the neighborhood of their 
banks, or by permitting the original discount rate to 
adjust itself so as to compensate for the loss. 

In a rather marked manner the par collections contro- 
versy recalls the old contest for sound banking methods 
in the wild-cat days prior to the Civil War. Then banks 
customarily refused to meet willingly their obligations at 
par. Then they sought court action to avoid payment in 
full of their obligations. Then they endeavored to prevent 
the development of a system whereby the parity of all the 
elements in the currency system could be maintained. 
Then, however, the controversy had to do with bank notes 
and not with checks. But the checks of to-day occupy the 
place of the note issues of yesterday. Issues of banks pay- 
able to bearer are becoming relatively less important. 
More and more their position is being occupied by checks. 

A temporary loss of profit to a portion of the banks 
should not be permitted to impede the development of the 
system of par collections. Undoubtedly some banks have 
a grievance. In some cases the reserve officials may have 
displayed an excess of zeal in their coercive measures. It 
may have been true that the reserve administration has 
not always been absolutely sincere in its defense of its own 
course of action. In many instances its interpretation of 
the law was not the only reasonable one ; in other instances 
reserve officials advertised their own indifference to the 
terms of the law and insisted their function was solely to 
administer the statute as bequeathed to them by law- 
makers, while at the same time they were exerting every 
endeavor to prevent a legislative change. Nevertheless, 
the writer believes that in the par collections controversy 



CHECK COLLECTIONS AND CLEARANCES 49 

the Board has displayed rare good tact in coordinating 
concession and firmness; that, in so far as it has possessed 
discretionary power, it has employed it solely for the pur- 
pose of correcting former abuses in our methods of domes- 
tic exchange. 



CHAPTER III 

STATE BANK MEMBERSHIP IN THE FEDERAL 
RESERVE 

At the time of the framing of the Federal Reserve Act few 
problems presented more difficulties than those relating 
to the requirements for admission into the new system. 
A priori the weight of advantage seemed to lie on the side 
of a large membership. Not only would a small member- 
ship mean that the resources of the reserve banks would 
be small, but also that a large number of banks, by remain- 
ing outside the system, would not be affected directly by 
the policies of the reserve administration. In its open 
market, or purchase operations, a reserve system of limited 
membership would not have the funds to exercise any 
large measure of control over the money market by com- 
peting with private^institutions. In its rediscount opera- 
tions few banks would be dependent upon the reserve and, 
accordingly, capable of being affected by the rate policy 
of the Federal Reserve Board. 

On the other hand, however, it was generally agreed 
that it would be a mistake, perhaps irretrievable, to make 
in the beginning too many concessions in order to secure 
the entrance of a large number of banks. The assets of the 
reserve banks would consist largely of paper endorsed by 
member banks. Should this paper prove to be of inferior 
quality, the resources of the reserve system must be 
impaired. The character of the reserve management, 
furthermore, must depend largely upon the member insti- 
tutions. Out of the nine district directors six were to be 



STATE BANK MEMBERSHIP 51 

chosen by the member banks. The importance of an able 
membership in the district directorates was clear to all. 
It could not be expected that the Federal Reserve Board 
could concern itself greatly with the detailed application 
of its policies to individual cases. Such duties must de- 
volve largely upon the district directorates. Too great 
liberality as regards membership might also produce 
unfortunate results outside the system. In the attempt to 
maintain a place for State non-member banks, State legis- 
latures might lessen the strictness of banking laws, and 
thus create an unhealthy situation in which the State and 
the Nation would be obliged to compete one with another 
for more lax, rather than for more sound, conditions of 
bank control. Subsequent history furnishes some con- 
firmation as to the correctness of this fear. From the 
Report of the Federal Reserve Board for the year 1915^ 
we read that some States had lowered reserve requirements 
materially since the adoption of the Federal Reserve in 
order to enable non-member institutions to compete more 
effectively with the members. 

It was understood also that early mistakes in the direc- 
tion of excessive conservatism could be corrected more 
easily than those of excessive liberality. It is easier to 
grant concessions than to employ new measures of control. 
Since, in all probability, the reserve framework must be 
altered after some years of experience, it appeared prefer- 
able to build a small superstructure on a sound foundation 
rather than a lofty though shaky banking house upon 
imperfect supports. 

Too great strictness in the beginning, however, might 
defeat the purpose of the lawmakers. If the reserve insti- 
tutions should not display at an early date the strength 
which comes from a large membership, popular faith, and 

* Page 13. 



52 FEDERAL RESERVE POLICY 

accordingly popular support for the new banking system 
might disappear. It is therefore easy to understand the 
difficulties of applying the preceding general observations 
to the specific facts of initial organization. 

Over a portion of the banks of the country, the national 
banks, the Federal lawmakers possessed mandatory power. 
The only alternative to membership for these institutions 
would be the surrender of their national charters. Since, 
furthermore, it was expected that most of these banks 
would discern the helpful possibilities of the system, the 
strict provisions were inserted in the law that any national 
bank failing to signify its acceptance of the terms of the 
act within sixty days after proper notification to subscribe 
to the stock of its district reserve bank must cease to act 
as a reserve agent. If within one year after the passage of 
the act it failed to comply with the provisions of the act, 
it must forfeit its Federal charter. During the days of 
organization, many insinuations were current regarding 
the refusal of some of the country's most powerful na- 
tional banking institutions to accept these terms. But it 
finally appeared that in many cases the motive for these 
veiled threats represented pressure to secure more favor- 
able terms in the act or the endeavor of some of the banks 
which favored the bill to get the public in the correct 
psychological attitude for sanctioning the plan. It may well 
be that after the experience with the Aldrich plan, a scheme 
interpreted primarily as a measure of public control or 
public coercion would enlist popular support more easily. 

Over the State banks, however, direct power of control 
was lacking. To secure their admission permissive and 
not mandator}' provisions were inserted in the act. The 
more important conditions of membership for these banks 
were the following : ^ 

* See section 9 of the original act. 



STATE BANK MEMBERSHIP 53 

(a) First, they must comply with the requirements 
relating to capital and reserves imposed by law upon 
national banks. Laws relating to national banks prohibit- 
ing the purchase of or loans upon their capital stock, the 
withdrawal of capital, or its dissipation through payment 
of unearned dividends, must also apply to State member 
banks. Their capital, furthermore, must be such as to 
entitle them to become national banking associations 
according to the population of the place in which they were 
situated. 

(b) Secondly, they must submit to examinations and 
regulations prescribed by the Federal Reserve Board, and 
must make certain reports of dividends to the Comptroller 
of the Currency. In the event of failure to comply with 
the terms of the act or with the regulations of the Reserve 
Board, they could be required to surrender their stock in 
the reserve bank. 

(c) In the third place, the banks must conform to the 
provisions of law imposed on national banks "respecting 
the limitation of liability which may be incurred by any 
person, firm, or corporation to such banks." 

These were the pertinent provisions of the law. What 
has been their effect upon the entrance of State banks. 
Historically, State admissions may be classified as falling 
into two periods : first, the period succeeding organization 
to June 21, 1917; second, that which followed the summer 
of 191 7. Let us first consider the State admissions in the 
early period. 

On June 2^], 1914, it was announced that only fifty State 
banks had made application for membership.^ In the 
Report of the Federal Reserve Board for the year 191 4 we 
read : ^ 

^ See news item in the Commercial and Financial Chronicle, July 4, 19 14, 
p. 16. The Federal Reserve Bulletin was not published until May i, 1915. 
' Page 20. 



54 FEDERAL RESERVE POLICY 

Since the passage of the Federal reserve act, there have been 
converted into National banks 93 State banks and trust com- 
panies, with a capital and surplus of ^9,151,306. There have 
been admitted to the system as members thereof 9 State banks 
and 4 trust companies, the aggregate capital and surplus of the 
13 institutions being $17,884,000. Those State institutions 
which have already been admitted to the system have entered 
upon the understanding that they are to accept any regulations 
the Board may make regarding the conduct of member banks. 
There are pending at the present time 51 State banks and trust 
companies. These applicants have preferred to await the 
issuance of regulations governing the admission of State banks. 

Three years later, June 21, 191 7, 53 State banks and 
trust companies with aggregate capital and surplus of 
^78, 491, 165 and resources of ^825, 000,000 were members.' 
In view of the infinitely larger number and resources of the 
non-member institutions, it appears in this first period 
that the conditions of membership were not appealing to 
the great body of State institutions. 

To what facts shall we attribute this unwillingness to 
join. Would it not appear that the statutory provisions 
regarding eligibility were extremely liberal? Were not the 
general terms of the act such as to render attractive mem- 
bership for the typical country institutions? For one mat- 
ter, small institutions could not object seriously to the 
method of selecting district directors. The method 
adopted was specially devised to ensure representation for 
the smaller banks. Legal reserve requirements, further- 
more, were reduced by the act for all member institutions.' 
The statute also contained no prohibitory measure regard- 
ing loans on real estate. The regulations of the Board 
regarding real estate loans were liberal, merely requiring 
that they be not carried in such liberal amounts as to 

^ Cf. Report of the Federal Reserve Board for the year 1917, p. 14. 
» If State laws should impose higher requirements, these would govern banks 
chartered by the State. 



STATE BANK MEMBERSHIP 55 

impair the general liquidity of the bank's assets. In view 
of the great reliance of many state banks upon real estate 
loans, the generosity of these provisions was of great im- 
portance. 

First among the reasons explanatory of the refusal of 
the great number of State banks to pay the price required 
to share in the benefits of the organization was the doubt- 
ful legal position of the applying bank. Regarding this 
matter the following news item published in the Commer- 
cial and Financial Chronicle for July 4, 1 914, is pertinent: ' 

Advices from the Organization Committee state that there 
are only twenty States in which the Treasury Department 
officials are sure that it is possible for State banking institutions 
to become members of the new Federal reserve system without 
some modification of the laws. These States are Vermont, 
New York, New Jersey, Delaware, Maryland, Virginia, West 
Virginia, Kentucky, Tennessee, Ohio, Indiana, Illinois, South 
Carolina, Alabama, Mississippi, Arkansas, Texas, Arizona, 
California, and Oregon. Two of these States — Kentucky and 
South Carolina — passed enabling acts since the passage of 
the Federal Reserve Act which make it possible for the State 
banks and trust companies to enter the Federal reserve bank 
system. In New Mexico and Montana it is possible for trust 
companies, but not for State banks, to become member banks 
of Federal reserve banks. The information of the Reserve 
Bank Organization Committee is based largely, it is said, on 
letters written by State officials in reply to inquiries concerning 
their State laws and the necessity for amendment of their 
statutes, so that their financial institutions may participate in 
the new system. Without exception, it is added, the State offi- 
cials gave assurance that steps would be taken to make changes 
in State laws which will enable State banks to join the Federal 
reserve banks, if they so desire. However, in many States the 
legislatures do not convene until 19 15. 

Gradually, however, the necessary legislation was en- 
acted in most States and difficulty on this score largely 

' Page 16. 



56 FEDERAL RESERVE POLICY 

removed. But the delay thus enforced may have caused 
some State banks, whose enthusiasm was aroused in the 
beginning, to postpone appHcation at a time when interest 
in banking reform was the most intense. With each day of 
delay the general attitude became more and more one of 
indifference. The money market was easy in the first few 
years succeeding 19 14 and the need did not appear for any 
great reliance upon the Federal Reserve. In the interval 
during which the permissive legislation was being framed, 
State bankers had ample opportunity to study the terms 
of the statute and analyze its apparent defects. Some of 
the resulting objections were sound and some were un- 
sound. But attitude toward membership was primarily a 
matter of the bankers' beliefs and only secondarily a mat- 
ter of the financial soundness of their views. 

Among the most emphasized of difficulties was the fear 
that membership would subject State banks to many 
prohibitions applying to national banks even though these 
prohibitions were not contained in the Federal Reserve 
Act. For instance, it was asserted frequently that mem- 
bership would subject the shareholders to double liability 
in the event of insolvency, even though the law in the 
State of incorporation did not impose such requirements. 
This fear, however, was soon dispelled by the publication 
of an Opinion of Counsel in the September i, 19 15, issue of 
the Federal Reserve Bulletin,'^ in which it was held that this 
provision of national banking law was not applicable to 
State banks. The only double liability resulting from 
membership in the Federal Reserve Act was that pertain- 
ing to the stock subscriptions in the reserve banks. Liabil- 
ity of shareholders on this account would be small. Of 
course, State member banks would be subject to the regu- 
lations of the Reserve Board. But these regulations must 

» Page 273, 



STATE BANK MEMBERSHIP 57 

be based upon, rather than in conflict with, statutory law. 

But aside from restrictions and limitations of powers, 
what about the advantages of membership? Would the 
rediscounting privilege in particular be of any great benefit 
to the great number of State banks? More specifically 
would State banks possess much of the paper eligible for 
rediscount? In the days of organization there was current 
a general belief that the Board would require financial 
statements of the maker of the paper to accompany redis- 
count applications. In its first regulations such conditions 
were imposed as a basis for ultimate procedure. But small 
banks ordinarily do not need to require, and often are not 
in a position to demand, such statements. It is not strange, 
therefore, that in a referendum conducted by the Bankers' 
Information Service of Washington^ the consensus of 
opinion was : . " * ' 

That although they will be compelled to pay a portion of 
their capital into the capital of the Federal Reserve System, 
where it will be tied up, they may receive no benefit because the 
class of commercial paper they handle is not eligible for dis- 
count under the regulations of the Federal Reserve Board. 

Expressing the same prevalent view, also, was the follow- 
ing editorial extract from the ComTnercial and Financial 
Chronicle: ^ 

Manifestly, since the regional Reserve bank is made up out 
of the stock contributions of all the banks large and small, 
nationals, proportionate to their stock and surplus, the benefits 
of the system should inhere to each in like manner, and the 
access for rediscount should be free to all. Yet we find that the 
status of the large bank and the small, or the country bank, is 
reversed by the provisions governing rediscount. Formerly it 
was the country bank that rediscounted its paper most freely, 
the large central institutions rediscounting very little and that 
against principle. Now, such are the provisions governing that 

» Cf. Commercial and Financial Chronicle, March 27, 1915, p. 1047. 
' Issue of January 20, 1917, p. 197. 



58 FEDERAL RESERVE POLICY 

kind of paper admissible, the city bank is meant to be, and can 
be, the easy and extensive borrower at the Federal Reserve 
Bank, while the country bank finds it extremely difficult to 
come within the provisions, owing to the nature of its local 
business, and is, in fact, scarcely at all a borrower from the said 
bank. 

As a matter of subsequent history such fears do not 
appear to have been justified. In later chapters evidence 
will be presented that the reserve administration went the 
limit of liberality in its endeavors to make the reserve 
banks useful to all classes of institutions. Requirements 
concerning the filing of financial statements were altered 
early in 19 15 so as to constitute virtually no bar to the 
applying member bank. The testimony of reserve bank 
directors has been almost unanimous that where the re- 
serve bank was permitted to cooperate, it was found the 
member bank's portfolio contained much paper, either 
directly admissible, or of such a character as to enable it 
easily to be made eligible. Confirmatory of such a view 
are the following remarks of Governor Strong, of the New 
York Reserve Bank, before a group of the New York State 
Bankers' Association:' 

The statement has also been made by some bankers of our 
district that very little, if any, of the paper held by their banks 
is eligible for rediscount with the Federal Reserve Bank. Those 
bankers who make this statement are liable to create the impres- 
sion that this opinion is held generally by member banks; but 
an examination of statements filed with us disclosed that only 
about 80 banks, out of our 480 members, reported that they 
had very little, if any, paper eligible for rediscount. With these, 
we have communicated, in order to ascertain upon what theory 
their reports were based. By correspondence and personal 
interview, with many of them, we havie satisfied them, as well 
as ourselves, that one half or more of the paper they hold is 
eligible for rediscount. 

' A part of this address is printed in the Commercial and Financial Chronicle, 
June 5, 1915, p. 1880. 



STATE BANK MEMBERSHIP 59 

Such conclusions as these represented the usual results of 
investigation in other districts. 

In the rare cases where no eligible paper existed, the 
resources of the reserve bank might furnish indirect aid. 
The needy member bank might borrow on its note pay- 
able from another member bank which did possess eligible 
paper. Furthermore, eligible paper might be purchased 
from commercial paper houses or from other banks. Such 
paper, rediscounted, would increase the reserve of the bor- 
rowing institution; while, if arrangements could be made 
whereby the seller would obtain for the time being only a 
credit upon the bank's books, payment for this paper need 
not mean an immediate and corresponding loss in cash or 
reserve money. 

The above arguments were addressed to the State banks 
however, largely from the point of view of their collective 
strength and not that of individual profit. From the stand- 
point of its own individual gain the necessity was not 
always clear for joining a set of rediscount institutions 
whose funds should be husbanded carefully for emergen- 
cies. From a selfish viewpoint many a bank might reason 
that the reserve system might be maintained by other 
institutions; that so far as it required rediscount aid, it 
could rely upon its old city correspondents, who in turn 
could secure aid from the reserve banks. With such insti- 
tutions it had in the past maintained occasional redis- 
count relations, and it appeared easier to continue these 
old customs than to take the trouble of investigating redis- 
count regulations applicable to the new reserve banking 
system. Particularly likely was such a position to be taken 
at a time of great ease in the money market. 

In other situations it was not so much a matter of inabil- 
ity to ascertain the advantages of membership, but rather 
a belief that admission would involve direct disadvantages. 



6o FEDERAL RESERVE POLICY 

In this connection discussions of systems of check clear- 
ances assumed much importance. Would the reserve 
banks develop clearing departments which would remove 
the necessity of depending upon outside city correspond- 
ents? The law gave discretionary power to the Reserve 
Board to require reserve banks to act as clearing agencies, 
but did not make this function mandatory. If this service 
was not certain to be developed, membership might prove 
costly. In addition to deposits with reserve banks, ac- 
counts with city correspondents for clearance purposes 
might continue to be necessary. There was no probability 
that city banks would discontinue bidding for country 
bank deposits. As long as they paid interest on bankers* 
deposits it would seem preferable to maintain deposits 
with them than with the reserve banks which paid no 
interest. 

But even if the reserve banks should make provision for 
clearances, it was not certain that the new facilities would 
offer any economies in making collections. What if the 
reserve banks should refuse to clear checks drawn on non- 
member institutions? Unless checks on both classes of 
banks were to be cleared, members might be obliged to 
maintain balances with city correspondents for the collec- 
tion of non-member bank items in addition to those 
deposited with reserve banks. 

There was also uncertainty about the future rights of 
banks to deduct exchange on remittances for their own 
checks. As indicated previously, such charges constituted 
a large part of the profits of some of the smaller institu- 
tions and the prevailing custom was one working in favor 
of the country bank. In the early stages of the bill in Con- 
gress, the provision prohibiting these exchange deductions 
proved very shocking to these banks. Although this objec- 
tionable provision was modified later, it was doubtful 



STATE BANK MEMBERSHIP 6i 

whether the rights of country banks as determined by 
established custom was sufficiently safeguarded. The con- 
cessions granted to them in the final draft of the bill pre- 
served their rights to deduct exchange only to the extent 
that costs were incurred in collection and remittance. It 
was foreseen by some that it was within the province of 
possibilities for the reserve collection system to develop in 
such a way as to eliminate all costs incurred in remittance. 
Would not the presentation of checks at the counter de- 
stroy ^ the justification for such charges? If so, would it not 
be better to refrain from adding to the resources and 
thereby to increase the prestige of the reserve system until 
definite guarantees were given regarding the right to con- 
tinue to impose such charges? * 

On what terms also could State member banks withdraw 
from the system? Since the days of Andrew Jackson no 
American bank had had any experience with such a bank- 
ing system. The success of the Federal Reserve was prob- 
lematical. Its future relations to member banks must 
depend largely upon its management. It might become a 
helpful organization securing for our banking system a 
stability never before possessed. On the other hand, it 
might become the ** monster'* of the time of the Second 
United States Bank. If so, could an early mistake in 
becoming a member be corrected easily? Must withdrawal 
necessitate voluntary liquidation? 

Particularly important were such questions to those 
State banks which were performing functions not legal 
for member national banks. If, after membership, such 
functions were being exercised, would inability to with- 
draw necessitate the abandonment of that kind of business? 
It is true that in its early regulations the Board endeavored 
to calm the fears of the banks by making such withdrawals 

' See supra, pp. 34-37- 



62 FEDERAL RESERVE POLICY 

easily possible. But the Federal Reserve Board was a 
body, not with a permanent, but rather with a shifting 
personnel. In the course of time, because of a change 
either in viewpoint or membership, its regulations might 
be altered. Regulations, alone, did not seem to provide a 
sufficient safeguard. 

Provisions regarding examinations were also distasteful 
to many State banks. By the terms of the statute certain 
powers of examination were conferred upon the Federal 
Reserve Board, and the Comptroller of the Currency had 
the right to require statements of condition and operation. 
These powers of examination and inquiry were to be added 
to those possessed by the State Banking Department and 
mayhap also to those of the local clearing house. An 
excess of examination was easily possible. Not merely 
might this involve much loss of time to the officers and 
clerical staff of the bank, but examination is always unwel- 
come because of the possibility of bank secrets being 
spread in this way. It would be much more difficult to 
trace the origin of such disclosures when examinations 
could be conducted by so many differently constituted 
bodies. 

In order to quiet discontent on this score, the Board 
made every feasible concession. Particularly, since every 
bank was to be contingently liable for its rediscounted 
paper, and because neither the Board nor the district di- 
rectorate could be expected to make careful investigations 
of the credit standing of the original borrower in all cases, 
it was unwilling to dispense with the investigation. But 
wherever possible there was to be cooperation with the 
State banking authorities in order that visits of examiners 
might fall as nearly as possible on the same days, and in 
order that there should be no useless duplication of work. 
In these ways objections were somewhat mitigated. 



STATE BANK MEMBERSHIP 63 

It was understood generally that the prime purpose of 
the new banking system was not to secure profits for 
stockholders. Dividend provisions were written in the act 
merely to lessen the possibility of total loss of income on 
the capital subscription to the reserve bank. Nevertheless, 
the average banker could not refrain from taking into con- 
sideration this aspect of the question. Under the terms of 
the law six per cent represented the utmost dividends 
possible on the stock of the reserve banks. Additional 
earnings must go to the Government as a franchise tax, or 
to surplus. In the early years, even six per cent dividends 
seemed impossible, in view of the small volume of redis- 
counting and there was the fear of spreading, by virtue of 
excessive open-market operations, the belief that the 
reserve banks were designed to compete with, and not to 
render service to, the member institutions. Many banks 
felt their capital could be made to earn much more than 
six per cent, and were unwilling to place it, even in small 
quantities, in a field where its profit-getting opportunities 
were thus limited. 

Because of these numerous doubts, queries, and objec- 
tions, because the state of the money market was not such 
as to create great dependence upon the Federal Reserve, 
because arguments were based so largely on advantage to 
the group and possibly not to so great an extent on the 
self-interest of each bank, it does not appear surprising 
that the great number of banks, not accustomed to assum- 
ing positions of leadership in the banking fraternity, 
should prefer to await future developments ; that, in other 
words, they adopted the policy of watchful waiting. It is 
no doubt true that the assumption of this attitude placed 
the non-member institutions in a stronger strategic posi- 
tion. It was not to be expected at the time of the framing 
of the original act that the lawmakers would make every 



64 FEDERAL RESERVE POLICY 

feasible concession to the State institutions. With more 
experience in the operation of the system, further conces- 
sions could be made later. And possibly the framers of 
the act had in mind the desirability of holding back some- 
thing for future bargaining purposes. At any rate, it is 
probable that the few State institutions which joined prior 
to the middle of 19 17 were those which were strongly 
impressed by this opportunity of stamping themselves 
with whatever guarantees of soundness and progressive- 
ness membership in the Federal Reserve implied. Mem- 
bership was an advertising feature of no mean advantage. 

But after the date of our participation in the World War, 
the situation altered itself abruptly. It was understood 
everywhere that war finance must increase greatly the 
demands upon all classes of banks. Not merely was it 
expected that the general level of commodity prices was 
destined to advance, but the necessities of military de- 
mands must throw greater strain upon our productive and 
industrial organization. To wait longer in applying for 
admission might prove costly. Entrance into the Federal 
Reserve could not be accomplished on the moment ; some 
delay must be encountered while the merits of the applica- 
tion for entrance were being considered. Previously the 
Reserve Board had rejected many applications because 
the past record or present condition of the bank was unsat- 
isfactory.^ Nor was there certainty that indirect aid could 
continue to be had from the Federal Reserve. The 
increasing strain upon the banks might place the city cor- 
respondent institutions in a position where they must 
think more largely of their own requirements. At the 
same time the occasion appeared ripe for some of our high 
Government officials to base their pleas for membership on 
patriotic motives. Early in May, 19 17, a letter from Secre- 

^ Cf. Report of the Federal Reserve Board for 19 15, p. 12. 



STATE BANK MEMBERSHIP 65 

tary McAdoo ' indicative of such appeals was read before 
the Executive Council of the American Bankers* Associa- 
tion. The following sentences may be quoted from this 
letter: 

The time may come when the financial resources of the coun- 
try will not be commensurate with the national purpose, if the 
nation remains half State bank and half national bank in its 
organization. The State banks will find greater security for 
themselves, if disaster should threaten, if they are members of 
the Federal Reserve system ; and the system will be irresistibly 
strong if the State banks unite with the national banks in mak- 
ing them an extremely useful national instrument. 

I commend this question to your earnest and patriotic con- 
sideration, with the sincere hope that love of our common 
country should surmount every other consideration and bring 
about this supremely desirable result. 

At the same time it began to appear as if the non-mem- 
bers had gained all possible advantage from remaining 
aloof. In an address delivered in Chicago in April, ^ Paul 
M. Warburg called attention to the fact that the Board 
had gone the limit in its endeavors to provide favorable 
terms for the entrance of State banks. He insisted that 
since State banks profited by the institution they were 
under obligation to support it. 

In the matter of friendly legislation much progress had 
also been recently accomplished. In the previous year or 
so some of the few States which had been tardy in enacting 
the necessary enabling legislation wrote statutes empower- 
ing State institutions to become stockholders in the Fed- 
eral Reserve Banks. These States were Delaware, Idaho, 
Kansas, Montana, North Dakota, South Dakota, and 
Washington. Furthermore, Federal legislation of very 

* This letter is printed in part in the Commercial and Financial Chronicle for 
May 12, 1917, pp. 1834-35. 

» Cf. Commercial and Financial Chronicle, April 14, 1917, pp. 1450-51. 



66 FEDERAL RESERVE POLICY 

great importance was enacted in the amendment to the 
Federal Reserve Act on June 21, 19 17. The most impor- 
tant concessions therein granted were the following : ^ 

1. Any State bank or trust company desiring to withdraw 
from membership in a Federal Reserve bank may do so, after 
six months' written notice shall have been filed with the Federal 
Reserve Board, upon the surrender and cancellation of all its 
holdings of capital stock in the Federal Reserve bank. 

2. Subject to the provisions of this act and to the regulations 
of the board made pursuant thereto, any bank becoming a 
member of the Federal System shall retain its full charter and 
statutory rights as a State bank or trust company, and may 
continue to exercise all corporate powers granted it by the State 
in which it was created. . . . 

The first of these concessions placed in definite statu- 
tory form what previously had been merely a ruling of the 
Board. In case withdrawal should be desired, voluntary 
liquidation would no longer be necessary. By the second 
concession guarantee was given that entrance into the 
system need not result in the loss of rights and powers 
possessed at the time of entrance, provided these were not 
in conflict with the terms of the act or the regulations of 
the Board. And aside from the clauses relating directly 
to the terms of membership in the system, a further wel- 
come feature of this amendment was the lowering in the 
legal reserve minima. After these statutory concessions 
had been granted, the President felt justified shortly 
afterward in asserting "" that ''membership in the Federal 
Reserve system is a distinct and significant evidence of 
patriotism." 

The effect of these appeals, of these statutory changes, 
and of the altered financial condition of the country was 

^ See Section 9 of the amended act. 

^ Statement of President Wilson made public through the Federal Reserve 
Board. See Bulletin, November, 1917, pp. ^2^-2^. 



STATE BANK MEMBERSHIP 67 

soon made manifest by an increased membership. It has 
been remarked that on June 21, 19 17, the number of mem- 
ber State institutions was 53 with total resources of ?825,- 
000,000. By January 31, 19 18, 296 State institutions with 
total resources of more than five billions of dollars had 
become members.^ By September i, 192 1, more than 1600 
State institutions were members with total resources of 
nearly ten billions of dollars. ^ 

It seems undeniable, therefore, that remarkable suc- 
cess was achieved finally in enlisting members from State 
banks and trust companies. It is true that the total num- 
ber of non-member institutions, with resources, enormous 
in the aggregate, far outnumber those which have joined. 
Many of these, however, would not be eligible for member- 
ship, and rnany would not add to the strength of the sys- 
tem if they were admitted. It should not be forgotten that 
a number of applications have been refused, and the effect 
of these refusals has undoubtedly influenced many other 
banks, whose financial strength was somewhat similar, 
not to make applications. It is true that many strong and 
powerful institutions remain outside the fold, but suffi- 
cient success has been achieved to render improbable the 
danger of warfare between members and non-members. 
When one recalls that in one matter of the utmost impor- 
tance to the State banks — the clearance and collection of 
checks — no concession of principle was made, it appears 
that the Board should be lauded for its general good tact 
and administrative efficiency. Few proposals of the sort 
once most earnestly advocated are now to be heard, pro- 
posals which if worked out might have split the country 
into two rival camps, proposals that non-members estab- 
lish a country-wide clearing system of their own. Of 

* See Bulletin, February i, 1918, p. 92. 

' See ibid., issue of September, 192 1, p. 1078. 



68 FEDERAL RESERVE POLICY 

course It may be true that the accretion in membership 
was merely the by-product of a too Hberal discount policy. 
But this is another problem and calls for special discussion 
in a later chapter. 

One interesting aspect of the State bank membership 
problem remains for discussion. What has been the effect 
of the legislative efforts to attract State bank members 
upon laws governing the operations of national banks? 
With no concession to national banks their position as 
competitors of State banks would become less secure. 
There was danger of stunting the growth of the national 
banks. To check this danger, legislation was enacted 
broadening under certain circumstances the powers of 
national banks. Legislation of this sort was contained in 
the act of September 26, 19 18. The import of this can be 
understood best by quoting an Opinion of Counsel of the 
Federal Reserve Board as to its application:^ 

Under the provisions of section 1 1 (k) as amended by the act 
of September 26, 191 8, the Federal Reserve Board may properly 
permit any national bank to exercise any of the fiduciary 
powers authorized by that section, unless there is some express 
provision of the laws of the State in which such bank is located 
which either directly or by necessary implication prohibits 
national banks from exercising such powers, and even if there 
is such an express statute, the Board may issue its permit if any 
State bank, trust company or other competing corporation in 
that State is permitted to exercise the powers applied for by 
the national bank. 

An indirect result of the problem of State bank member- 
ship has thus been to encourage the tendency toward 
"department store" banking. It is probable that there 
will be a further development of this tendency in the 
future. Many national bank directorates feel that the law 
is not quite fair to their institutions. In many respects, 

' See Btdktin, April, 1919, p. 363. 



STATE BANK MEMBERSHIP 69 

such as that of prestige, membership in the Federal- 
Reserve serves all the purposes previously requiring 
national incorporation. These directorates are considering 
reincorporation as State banks in order to gain the advan- 
tage of more liberal legislation. Particularly in the matter 
of the establishment of branches there is a general demand 
that national banking law be made more affirmatively 
liberal. 



CHAPTER IV 
ADVANCES OF RESERVE BANKS— REDISCOUNTS 

The purpose of this chapter is to explain the machinery 
and conditions under which the funds of reserve banks 
through the medium of rediscounts may be made avail- 
able for member institutions. The reader will bear in mind 
that rediscounting is not the sole means by which reserve 
banks may employ their resources. Through an amend- 
ment to the original act, later to be discussed, reserve 
banks secured authority for rendering direct aid by dis- 
counting the notes of the member banks themselves. 
Indirectly also, through their open-market operations, 
further aid may be extended. Our present purpose, how- 
ever, is to discuss one type only of reserve bank operations, 
rediscounts, or the discount of paper which originated at a 
prior date, the parties concerned being in most cases the 
member bank and one of its clients. 

It seems logical to give rediscounts rather than the 
other operations the place of priority in our discussion. 
Not for a considerable period after the date of inaugura- 
tion were reserve banks given permission to make direct 
advances to member institutions. While reserve banks did 
possess from the very beginning certain powers of direct 
dealings in the open market, such functions were not the 
most emphasized. In the exercise of their open -market 
powers the reserve banks often must assume the position 
of competitors of member banks ; their policies may have 
been adopted for the purpose of controlling the money 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 71 

market, possibly with the result of interfering with the 
profit-making operations of the member institutions. If 
conducted, not for the purpose of control, but merely 
for the sake of securing more complete employment for 
their resources, these direct dealings may lessen the de- 
pendence of the public upon the member institutions. 
Only in rediscount operations is the character of the 
reserve system displayed consistently as of a cooperative 
nature, only then does the reserve system appear as an 
institution designed to render service to its member banks. 
Since in the early years of operation every device of sound 
banking must be employed in order to secure the alle- 
giance of the individual banks of the country ; since with- 
out their generous support the Federal Reserve must have 
failed to secure the resources and influence necessary to 
enable it to function as intended, the helpful possibilities 
of the system have been the most advertised. To-day a 
layman, asked to define the functions of the reserve banks, 
would undoubtedly reply — they are institutions de- 
signed to aid member banks by rediscounting commercial 
paper. 

Statutory provisions regarding rediscounts are con- 
tained in section 13 of the act. The general purport of the 
terms of this section was to encourage sound methods of 
commercial banking and to maintain liquid the assets of 
the reserve banks. Accordingly reserve banks may redis- 
count only paper which arises in the short-time, self- 
liquidating operations of trade, industry, and agriculture. 
More specifically the leading provisions of this section 
were: 

(i) Reserve banks are permitted to rediscount paper en- 
dorsed by member banks which arises out of and the proceeds of 
which are employed for agricultural, industrial or commercial 
purposes. 



72 FEDERAL RESERVE POLICY 

(2) Paper covering merely investments or drawn for the 
purpose of carrying or trading in stocks, bonds, or other invest- 
ment securities is rendered ineligible. 

(3) The definition of ineligible paper, however, does not cover 
*'that issued or drawn for the purpose of carrying or trading in 
. . . bonds and notes of the Government of the United States." 

(4) Paper drawn for agricultural purposes or based on live 
stock may have a maturity at the time of discount by the re- 
serve bank of six months. Other eligible paper must have a 
maturity not in excess of three months. 

So much emphasis has been placed upon the desira- 
bility that rediscounted paper should comply with these 
requirements that it is commonly assumed that it would 
not have been in the interests of sound or conservative 
reserve banking to have included other varieties of eligible 
paper. Of late, however, some voices have been heard 
denying the assumption that eligible paper should be 
defined thus narrowly.^ In order that later we may form a 
judgment as to the desirability of the qualifications con- 
tained in the act, it may be well to recall some of the lead- 
ing objections offered to the rediscount of speculative or 
investment paper. 

First of all, it was believed that these restrictions were 
necessary in order to keep liquid the funds of the reserve 
banks. In the course of time it was expected that the loan- 
ing power of the reserve institutions would become the 
ultimate reserve of the country. Far more important then 
would it be that the reserve funds should be easily avail- 
able than those of any private bank. Member banks could 
rely if necessary upon the reserve institutions for aid, but 
no easily accessible source of relief would be open to the 
reserve institutions. Their reserves would constitute the 
last line of defense in a period of threatened liquidation. 

^ Cf. for instance, Anna Youngman, "The Efficacy of Changes in the Discount 
Rates of the Federal Reserve Banks," American Economic Review, September, 
192 1, pp. 463-86. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 73 

In the second place, there was a general desire to seize 
every opportunity offered by the establishment of the new 
system to encourage sound banking methods on the part 
of the member institutions. Not merely does the strength 
of the reserve system-depend largely upon the strength of 
the member banks, but the advantages to the public 
arising from the formation of the reserve system might be 
lost if member banks should be encouraged to invest too 
large a proportion of their resources in slow assets. From 
the standpoint, then, of the condition of member banks, 
every effort should be exerted to maintain the liquid char- 
acter of the paper in their portfolios. 

Certain objections, somewhat of a political character, 
also lay in the way of the admission of paper arising out of 
investment or speculative operations. As remarked in a 
previous chapter the support of the interior banks and of 
the business public could not easily have been secured for 
a plan whereby the reservoir of funds for investment and 
speculative activities could be increased by the use of the 
contributions of all member banks, large as well as small, 
metropolitan as well as rural. To repeat a former observa- 
tion, the Federal Reserve plan was directed largely against 
Wall Street; its support among a large class of bankers 
depended, not so much on any sound conviction as to the 
merits of the numerous technical objections to the old 
system, as to discontent arising out of the difficulties 
experienced by banks of the interior in securing the return 
of funds invested in 1907 in the securities market of New 
York City. Allegiance to the reform system could not be 
secured easily without the guarantee that the surplus re- 
serves of commercial banks should be kept available for the 
needs of commerce and agriculture instead of swelling in 
the slack seasons and years the reservoir of stock market 
funds. Rediscounting of speculative paper must be refused. 



74 FEDERAL RESERVE POLICY 

What, moreover, about the inflationary possibilities of 
the new system? Everywhere was it understood how, by 
the concentration of reserves and the resulting pyramiding 
of credits, the reserve system would make possible vastly 
enlarged amounts of bank advances. Would expanding 
credit grants, thus rendered possible, exert a lifting influ- 
ence upon the general price level and exaggerate the diffi- 
culties already generally attributed to a faulty standard 
of deferred payments? In answer to such queries there was 
a general denial by the members of a certain school of 
currency students of any direct connection between 
expanding grants of commercial credit and the general 
level of commodity prices. This school argued that only 
when bank funds were borrowed for investment or specu- 
lative purposes the cause of a resulting higher level of 
prices could be attributed to any enlargement of bank 
advances. The real. danger lay in pouring too large a 
proportion of the country's banking resources into the 
investment reservoir. Possibly the clearest brief statement 
of this point of view is that of Professor C. C. Arbuthnot 
in the American Economic Review for December, 1920.^ 
His statement was made for another application, but well 
summarizes certain views earlier expressed regarding Fed- 
eral Reserve policy. To quote from his argument: 

In the ordinary processes of business the credit of commercial 
banks is used to assist in the purchase and sale of marketable 
-] goods. It takes the form of short-time notes which are to be 

I paid from the receipts from the sold goods. The extension of 

credit to permit buying is accompanied almost simultaneously 
by an offer in the market of the salable commodities. The effec- 
tive demand for goods thus made possible is accompanied by the 
supply of goods. The equilibrium between supply and demand 
is not seriously disturbed and the extension of credit has no 

* Cf. pp. 779-80. The subject of Mr. Arbuthnot's article was "A Stabilized 
Dollar." 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 75 

lifting influence on the general level of prices. As long as com- 
mercial bank credit serves this purpose there is no inflation. 

As will be indicated later, this view does not harmonize 
with that of the writer. Nevertheless, with various modi- 
fications and refinements it represented the view of many. 
Since it was inevitable that the reduction of reserve min- 
ima under the Federal Reserve would expand greatly the 
potential volume of bank credit, acceptance of this view 
necessitated a careful attempt to restrict the use of reserve 
resources for investment purposes. 

The above fears of price inflation had to do with the 
probable results of too great advances to the investment 
market. But when bank funds are employed for another 
purpose, the withholding of goods from early consumption 
— for commodity speculation, in other words — there 
was general agreement as to the lifting influence upon the 
price level of the bank funds thus advanced. Clearly, it was 
unanimously agreed, reserve funds must not be made 
available to the commodity speculator. 

Many controversial points were involved in the argu- 
ments stated above. It is the writer's belief that to-day 
there is an even greater tendency to dispute the validity 
of some of these tenets. But their truth accepted, the 
practical problem became that of framing measures which 
would effectively discourage the use of reserve funds for 
speculation or investment. In other words, it was a matter 
of devising tests or standards according to which the com- 
mercial character of the paper offered for rediscounts could 
best be determined. Several possibilities received some 
attention in this connection. First, admissible paper must 
be of the double-name rather than of the single-name type. 
Second, statements of conditions of the maker's assets 
could be required. Finally, in a more informal way, reli- 
ance could be placed upon the knowledge of the applying 



76 FEDERAL RESERVE POLICY 

banker as to the purpose for which the funds originally 
obtained were employed. Let us first turn our attention to 
the matter of double-name paper. 

The case for admitting double-name paper only was 
based upon a number of arguments. In the first place, its 
form was such as to offer greater indication of the com- 
mercial nature of the underlying transaction. Every 
operation of trade involves at least two parties. If admis- 
sion of the indebtedness is evidenced by a draft, the seller 
of the goods becomes the drawer, the purchaser the 
drawee. If the promissory note is employed, the payee or 
his agent is the seller, the maker the purchaser. Since 
these two parties are always involved in a trade transac- 
tion, why not require their names and their combined 
security in the paper which arises when resort is had to 
bank funds. In case two-name paper cannot be supplied, 
there is greater likelihood that in the underlying transac- 
tion the purchaser is not to liquidate his account out of the 
proceeds of the sale of the goods, and the paper is not 
liquid. If two-name paper can be supplied, there is one in- 
dication, not conclusive to be sure, but informative, never- 
theless, of the liquidating character of the transaction. 

In the second place, it was asserted that single name paper 
indicates more often lax customs of trade credit. The buyer 
is more tempted to buy unwisely, the seller to overextend 
credit or accept bad debt accounts, when the buyer is not 
compelled to acknowledge immediately his indebtedness. 
Single-name paper often originates because of the desire of 
the buyer to postpone the date of formal acknowledgment 
of his obligation. At the time of shipment and for a certain 
period thereafter he insists upon being carried on the open 
book account. Inevitably this delay must increase the 
likelihood of bad debts, slow payments, expensive collec- 
tions — in short, irregularities in our trade credit methods. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 77 

As a special irregularity thus created, it was further- 
more insisted that single-name paper necessarily gives rise 
to many duplications. These duplications could usually be 
attributed to the ability of the buyer to avoid the im- 
mediate creation of paper which when discounted would 
render him subject to a call from the bank. In the absence 
of careful analysis of financial statements, single-name 
methods permit the same person to borrow from a bank and 
from a commercial paper house. Some firms established 
connections with several note brokerage concerns and sell 
through them all. The practice of registering with a trust 
company paper thus sold had its origin in the endeavor of 
some firms to prove they were not duplicating security in 
this manner. Some firms borrow largely on their showing 
of book account and later assign these to selling agents.^ 
If one party could not obtain bank funds without joining 
simultaneously the other party to the trade transaction, 
such duplications would become more difficult. 

Finally it was contended that the admission of single- 
name paper must encourage the acquirement of precisely 
the sort of paper for which there was little foreign demand. 
In Europe a broad market existed only for prime paper of 
the double-name type. One of the underlying purposes of 
the Federal Reserve Act was to create a constant open 
market for prime paper, both in the home and foreign 
markets. A broader home market alone would not solve 
difficulties due primarily to such international facts as 
excessive gold exports arising from an unfavorable balance 
of trade. In defining eligible paper a wonderful opportu- 
nity existed to correct the situation wherein commercial 
banks were induced to invest surplus funds in stock ex- 
change activities. But to secure the utmost of advantage 

» Cf. E. E. Agger, "The Commercial Paper Debate," Journal of Political 
Economy, July, 19 14, pp. 670-71. 



78 FEDERAL RESERVE POLICY 

the requirements of foreign as well as of domestic demand 
must be taken into account. Single-name paper possessed 
inferior standing abroad. 

Many objections of a practical character, however, must 
be met by those insisting upon the exclusive acceptance of 
double-name paper. One of the most obvious, as well as 
most compelling of these, was the very great lack of good 
double-name paper in the American market. It has been 
asserted that at the time of the framing of the act, trade 
paper arose in less than three per cent of the total credit 
transactions of the country.^ Of this three per cent a very 
large part consisted of paper arising in settlement of post- 
due accounts. With double-name paper alone admissible, 
it was clear that the reserve system could render little real 
aid to the member banks. If it was not to degenerate into 
an impotent and unused mechanism, it must take account 
of the actualities of the situation and not merely hypothet- 
ical or idealistic considerations. Of course the reserve ad- 
ministration would be expected to plan consistently for the 
development of more sound methods of trade and bank cre- 
dit. Some time must elapse, however, before any consider- 
able alteration of existing methods could be accomplished. 

The above argument could be addressed to practically 
all the commercial banks of the country. But an espe- 
cially appealing objection could be addressed to the great 
number of small bankers on the ground that double-name 
paper alone must mean discrimination in favor of the 
large city institutions. In the main, it was argued, the 
small bank is the bank of the retailer ; whereas the whole- 
saler, jobber, and manufacturer must depend on the urban 
banking house. Because of the small amount and informal 
character of his average credit transaction, the retailer 

1 Cf. E. E. Agger, "The Commercial Paper Debate," Journal of Political 
Economy, July, 1914, p. 663. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 79 

cannot offer his banker any large amount of double-name 
paper. Except in cases of post-due accounts and slow pay- 
ments, custom and competition do not permit him to 
demand notes or to require the acceptance of drafts from his 
customers. In the wholesalers* transactions, however, 
wherein considerations of custom must be somewhat less 
important relatively than those of business efficiency, a 
future field for the creation of double-name paper was dis- 
cernible. But what would be the justice and the political 
expediency of a programme which would admit as eligible 
only paper contained in large volume in the portfolios of 
the city institutions? Acceptance of this proposal would 
compel country banks to purchase paper in the open mar- 
ket in case they desired to draw upon the reserve. But the 
advantage of such a course of action would be dubious. It 
is true that rediscounting would increase the bank^s 
reserve. But payment for the paper purchased would tend 
to tear it down in corresponding degree. 

Neither, it was insisted, was there any guarantee that 
funds obtained by the discount of two-name paper would 
not be employed for investment or speculative purposes. 
The funds obtained by the discount of admissible paper 
might be put to any use desired. In the words of Moulton, 
written for another purpose : ^ 

It will be recalled, from our previous analysis of the relation 
of the commercial banking system to the financing of stock 
exchange speculation, to the outright purchase of securities, 
to the making of collateral loans for fixed capital purposes and 
to the activities of investment bankers engaged in the marketing 
of securities, that the funds of the commercial banking system 
constitute the support for the entire financial fabric, invest- 
ment and speculative, as well as commercial. 

Of course it might be argued that to make this class 
of paper alone admissible would increase its desirability to 
' Financial Organization of Society, p. 633. 



8o FEDERAL RESERVE POLICY 

the member banks. But ought not the general liquidity 
of the borrower's assets and not the form of the paper to 
determine the right to request Federal Reserve aid. 
Because of the nature of their operations some borrowers 
cannot gain possession of double-name paper. If their 
assets in general are sufficiently liquid, should not their 
paper be rediscountable? As Sprague puts it : ^ 

The fundamental point at issue is whether an analysis of the 
entire financial position of the borrower or a series of particular 
transactions affords the lender better safeguards against loss. 

It could be contended, furthermore, that discrimination 
in favor of double-name paper might tend to increase the 
volume of unsound paper. Eligibility for rediscounts is 
purely a matter of arbitrary definition. Nevertheless, it 
might become one of the principal bases offered in the open 
market for testing its worth. Single-name paper, because 
of the possible misuse of the funds, because of the fact that 
only one party is responsible, puts the purchaser on guard. 
He is not nearly so likely to avoid the usual safeguards of 
examination and inquiry when his paper is not of the sort 
encouraged by the definition of eligibility. In the discount 
of two-name paper, no margin of collateral over credit 
obtained would usually be required. 

In a pragmatic sort of way, some measure of truth may 
be contained in this objection. Too much attention to 
form might lessen dependence upon careful analysis of the 
borrower's condition. If such abuses should appear, how- 
ever, the method of correction would be easily available. 
Merely let there be redoubled devotion to the usual safe- 
guards. In Warburg's words :^ 

It has never been contended by the champions of the trade 

' See O. M. W. Sprague, "The Federal Reserve Banking System in Opera- 
tion," Quarterly Journal of Economics, August, 1916, p. 649. 
» See Bulletin, Jul> i, 1918, pp. 604-06. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 8i 

acceptance that these acceptances should be bought by any one 
who has not familiarized himself thoroughly with the financial 
condition of the maker of the paper; he should take this pre- 
caution just as if he were buying a single-name note, and as 
long as he does that there is no reason whatever why he should 
not be capable of judging solvency and standing from the state- 
ment of a borrower who sells the trade acceptance he receives 
just as he can from the statement of a firm which borrows only 
on its own note. 

Admonitions of this sort, however, were frequently 
sufficient to lessen the ardor of many advocates of double- 
name paper. It was expected by many that a change in 
the form of trade paper must lessen the need of tedious and 
careful examination. When it became apparent that a 
mere change in form could not accomplish everything, 
there was a marked reaction to the view that the main pre- 
requisite of eligible paper must be the general character 
of the borrower's assets. 

As a final objection to the sole admission of two-name 
paper, it was argued that its use would transfer part of the 
work of rating the credit of the buyer from the bank to the 
selling merchant. Under the single-name paper method the 
bank must satisfy itself regarding the standing of the bor- 
rower (the buyer). Under the double-name plan the borrow- 
er's ability to obtain credit would depend in the first in- 
stance upon the seller's rating of the buyer. Because of the 
addition of the seller's contingent liability in the bank bor- 
rowing, dubious trade paper might become the basis for 
bank credit. In other words, it was insisted that the buyer's 
bank ordinarily possesses superior means of testing the 
buyer's solvency to that of the seller of the merchandise. 

Undoubtedly there was a good deal of force in this argu- 
ment. But it merely emphasizes the necessity of careful 
analysis of the standing of the buyer as well as of the seller. 
It also brought into clearer relief the viewpoint that the 



82 FEDERAL RESERVE POLICY 

principal consideration was the credit rating of the parties 
and not primarily the form of the paper. There did not 
appear to be sufficient warrant for the absolute rejection of 
single-name paper. Accordingly, the principal statutory 
provision relating to eligible paper makes the test, not the 
form of the paper, but the purpose for which the proceeds 
have been or are to be employed. 

But were there not certain other feasible means of 
increasing the use of trade paper? Could not less strict 
qualifications and less complete information as to the 
nature of the transaction be required in the case of double- 
name paper? In view of the difficulties just disclosed 
regarding the dangers of insufficient examination, such a 
course would appear extra-hazardous. But if not this, 
could not the total volume of rediscounts obtainable by 
one member bank be made the greater in cases where the 
applications were in large part double-name paper? Objec- 
tion to such a policy was the probability that some sec- 
tions of the country would be unfairly treated. Many 
communities, particularly the rural and the village, could 
not be expected to originate any large volume of two-name 
paper. There thus remained the possibility of granting a 
preferential rate of discount to applications covering the 
new kind of paper. To anticipate future discussion, the 
policy of preferential rate treatment has been adopted 
during a large part of the period of reserve operation. 

The Federal Reserve Board's first regulations regarding 
discountable paper may now be briefly summarized. In an 
early communication, Circular Number 13,^ reserve banks 
were requested to confine their operations to short-time, 
self -liquidating paper arising from commercial, agricul- 
tural, or industrial needs, and to exercise particular care to 

' This circular is accessible in convenient form in the Commercial and FinaU' 
cial Chronicle, November 14, 1914, pp. 1416-17. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 83 

avoid furnishing capital merely for investment or specula- 
tive purposes. Funds desired for fixed improvements 
would fall in the ineligible class. The maturities of the 
paper rediscounted should be well distributed, and the 
paper should be non-renewable. To quote from the cir- 
cular regarding the distribution of the maturities : 

It is a general rule (in Europe) not to purchase paper having 
more than 90 days to run. The maturities of these notes and 
bills are so well distributed as to enable these banks within a 
short time to strengthen their hold on the general money mar- 
ket by collecting at maturity or by reinvesting at a higher rate 
a very substantial proportion of their assets. Acting on this 
principle, the Federal Reserve banks should be in position to 
liquidate, whenever such a course is necessary, substantially 
one third of all their investments within a period of 30 days. 
Departure from this principle will endanger the safety of the 
system. It is observance of this principle that affords justifica- 
tion for permitting member banks to count balances with Fed- 
eral Reserve banks as the equivalent of cash reserves. 

As a means of determining the self-liquidating character 
of the paper, the method of procedure is next outlined. 
The Board was evidently impressed by the desirability of 
considering more than the nature of the specific underlying 
transaction, for the procedure outlined to become effective 
after January 15, 1915, practically called for a statement of 
condition of the borrowing firm. Since, however, the 
Board did not wish to lay down rules which might involve 
needless delay or difficulty in rediscounting, it was not 
insisted that a statement of condition be attached to each 
bill sold to a reserve bank. But it was to be required as a 
basis of permanent procedure that the original borrower 
should file such a statement with his member bank. For 
the time being, certified accountants' statements need not 
be submitted. It was suggested, however, that at a later 
date these might be required. Even though the statement 



84 FEDERAL RESERVE POLICY 

of condition need not be attached to each bill, the paper 
must bear on its face evidence that it was eligible, and that 
the seller had filed a statement of condition with the mem- 
ber banks. This evidence might be vouchsafed by the 
officers of the member applying bank through the means 
of a rubber stamp. 

These regulations were exceedingly exacting, so far, at 
least, as methods of procedure were concerned. Few of the 
smaller banks, particularly those in the rural sections, were 
in position to supply the required evidence that a satisfac- 
tory statement of condition was on file. In the face of an 
almost entire lack of rediscounting, it soon appeared that 
the severity of these regulations must be relaxed. Accord- 
ingly, on January 12, 19 15, three days before these regula- 
tions were to become effective, the Board extended the 
date from January 15 to July 15 of the same year. But the 
lack of a genuine desire to rediscount still asserted itself 
and in Regulation B, Series of 1915,^ it was ruled that 
statements of condition need not be on file in certain types 
of borrowing where it was believed it would be difficult to 
obtain them. To be specific, these requirements were to be 
waived : 

1. If the bill bears the signature of the purchaser and seller 
of the goods and presents prima facie evidence that it was issued 
for goods actually purchased or sold ; or 

2. If the aggregate amount of obligations of such a depositor 
actually rediscounted and offered for rediscount does not exceed 
$5000, but in no event a sum in excess of 10 per centum of the 
paid-in capital of the member bank ; or 

3. If the bill be specifically secured by approved warehouse 
receipts covering readily marketable staples. 

In succeeding circulars regulations with a similar trend 
were sent out. In view of the very great desire of the Board 
to improve the admitted deplorable conditions in the trade 

» See BuUelin, May i, 1915, pp. 37-38. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 85 

and bank credit situation, it appears to the writer that the 
Board cannot be convicted of endeavoring to establish 
ultra-bureaucratic methods of procedure. 

The purposes of the Board's regulations were two-fold. 
First, they were designed to state the precise terms accord- 
ing to which the more general terms of the statute could be 
made applicable to individual cases; and, second, to lay 
down rules governing rediscount operations in cases where 
the statute appeared to be silent. But even the regula- 
tions themselves could not be expected to deal specifically 
with the multitude of complicated cases which must 
inevitably arise. Accordingly, as a means of disseminating 
such information, the Board began the publication in its 
official organ, the Federal Reserve Bulletin, issued monthly 
first of its own informal rulings, and second of the opinions 
of counsel in the Law Department. In these we find replies 
to the inquiries of member banks, reserve bank officials, 
private individuals, and governmental representatives. By 
these methods much was accomplished in the way of har- 
monizing the policies of the various district board direc- 
torates. To a very marked extent the wisdom or lack 
of wisdom of the Board's policies is set forth in these 
pronouncements. 

The difficulties of avoiding confusion and inconsisten- 
cies in these rulings are easily apparent. To consider that 
prime difficulty of fundamental application — when is an 
operation commercial and when is it merely investment in 
character? A distinction, such as this would involve, could 
not be set up by any generally accepted method of eco- 
nomic reasoning. Fundamentally this query touches a prob- 
lem which has never been withdrawn from the field of 
theoretical economic controversy — what is capital? Ever 
since the precepts of the science of economics have been 
formulated systematically, the masters have quarreled 



86 FEDERAL RESERVE POLICY 

over the proper means of delimiting this concept. To-day 
opposite viewpoints are still displayed. One school would 
define capital from the point of view of the form of the 
good — whether or not it is of a kind primarily applicable 
to the creation of other consumable goods. The other 
school would define solely from the acquisitive, individual- 
istic point of view. Thus capital comprises those goods, no 
matter what the form, which are employed not to provide 
direct psychic income, but rather to enable the possessor 
better to derive a money income. This fundamental diffi- 
culty appears again and again in the determination of 
eligible paper. 

Many less far-reaching criteria were current also in 19 14 
regarding the proper definition of commercial paper. One 
of these was this — it is paper the proceeds of which are 
employed in order to acquire readily salable goods. The 
note of the coal dealer to secure the funds for the purchase 
of coal to be speedily resold to his customers, of the fruit 
buyer to acquire fruit for his current sales, would be eligi- 
ble commercial paper. But what about paper arising in 
the individual's desire to acquire tracts of standing timber? 
The timber as well as the timber land might be sold speed- 
ily, yet the individual owner . might have in mind more or 
less permanent ownership. The nature of his possession 
might create no hardship in holding permanently. Unlike 
the coal or the fruit, the timber would continue to improve 
in physical quantity. There would be much more likelihood 
of its being held indefinitely than in the case of the coal or 
of the fruit. But should the paper be refused merely 
because the asset of the borrower and accordingly the 
security for the bank improves? 

In this case the existence of another quality of standing 
tracts of timber rendered more easy a statement of the 
Board's opinion. This extraneous quality enabled the 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 87 

Board to base its ruling on the desirability of preserving 
liquid the banks' assets. Timber is subject to forest fires 
and severe winds. To quote from the Bulletin for July i, 
1915:' 

While it is true that there are times when timber lands, that 
have been thoroughly cruised and reported upon by competent 
experts, are readily salable, there are other conditions relating 
to properties of this kind which must be taken into considera- 
tion. Forest fires sometimes destroy a good deal of standing 
timber, and sometimes wind storms greatly diminish the value 
of such properties. 

The precedent would be a dangerous one, as owners of coal 
and ore lands might ask to have their coal and ore in the grounds 
appraised on a royalty basis, and ask to have paper, based upon 
their holdings of such lands, made eligible for discount at Federal 
reserve banks. 

But without the possibility of relying upon this quality 
of timber land — possibility of great deterioration in physi- 
cal quality — how much more difficulty must have at- 
tended the ruling? 

Let us therefore suppose another case in which no such 
condition exists. What if the contractor wishes to borrow 
in order to secure funds for the erection of a building? Is 
his operation commercial, or investment, or even specula- 
tive in its nature? 

Here again the Board was enabled to rely upon a fact of 
attending circumstance — whether or not at the time of 
borrowing the contractor possessed a contract of sale. 
Thus we are informed by the Bulletin for July, 1920,' that 
the proceeds are for fixed improvements and the note is 
ineligible in case the paper is that of the owner. But if it is 
that of the contractor, it may be regarded as commercial in 
character. Thus another quality of paper is introduced — 

' Page 126. 
* Page 699. 



88 FEDERAL RESERVE POLICY 

existence of contract for sale of that which has been ac- 
quired or constructed by the use of the proceeds of the 
borrowing. 

But if intention to liquidate quickly is the uniform cri- 
terion, the Board must face another difficulty — one which 
must occasion frequent discontent with the management 
of the system. One borrower might be the maker of an 
eligible note, another of an ineligible note, even though in 
both cases the proceeds were employed to purchase the 
same sort of a good. In one case the Board held eligible a 
farmer's note to secure the funds for the purchase of farm 
tractors. Using this as a precedent, it was insisted ' by a 
corporation engaged in the business of furnishing motor 
transportation that its notes to secure funds with which to 
purchase motor trucks were eligible. This corporation ar- 
gued that its paper was even superior to that of the farmer 
since the life of a motor truck ordinarily is less than 
that of a farm tractor. Motor truck paper would be less of 
an investment nature than tractor paper. Accordingly the 
Board is here compelled to make a distinction dependent 
entirely upon a matter of degree. To quote a part of its 
ruling: 

Farm tractors constitute only a small part of the entire 
equipment of a farm, whereas the motor trucks of a corporation 
engaged in the business of furnishing motor transportation 
necessarily constitute a very large part of the corporation's 
entire equipment. If the notes of such a corporation, the pro- 
ceeds of which are used to purchase motor trucks, were declared 
eligible for rediscount by Federal Reserve Banks, the result 
would be that paper representing in the aggregate a very large 
part of the corporation's capital investment would be eligible 
for rediscount, and it would not be reasonable to assume that 
such notes could be liquidated out of the corporation's current 
revenues. 

* Bulletin, February, 1921, p. 191. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 89 

Obviously the task of deciding what is and what is not a 
fixed investment is fraught^with difficulty. Frequently the 
decisions do not meet the issue squarely. Dependence upon 
facts of attendant circumstance must make future rulings 
largely a matter of following precedent, with the danger of 
confusion, inconsistencies, and reliance upon arbitrary, 
discretionary judgment. 

But to summarize our conclusions as reached thus far 
''readily salable goods" is not a concept easily determined 
and easily applied. In some cases conclusions must depend 
upon the risks of deterioration ; in others, upon the exist- 
ence of contracts to sell. In others, it would seem to depend 
upon the extent to which the value of the goods acquired 
by the proceeds of the borrowing measure up to that of the 
other assets of the company. Fortunately for the Board, 
the provisions of the statute inserted the word mere in the 
prohibitory clause relating to investment paper. 

Let us next consider another basis for determining the 
eligible character of the paper. Are the proceeds to be 
employed to further some definite stage of production, 
distribution, or manufacture? If the proceeds are not to be 
employed in such a way as to hasten their journey toward 
acquirement by the ultimate consumer, clearly the expendi- 
tures were for capital and not for commercial purposes. 
But in practice it must be very difficult to determine 
whether a given operation is a necessary part of the process 
of production or commerce. How classify the note of the 
dealer who borrows in order to acquire grain or cotton 
which for the time being at least is not to be sold? Is mere 
warehousing to be considered a necessary part of the dis- 
tribution process? If it is thus to be considered, would not 
dangerous precedents be developed, precedents which 
might seem to justify Federal Reserve advances for com- 
modity speculation? What if the purpose of the borrower 



90 FEDERAL RESERVE POLICY 

was primarily to put himself in a position to create a tem- 
porary scarcity by withholding the goods from the market? 

No practice in market distribution is more frowned upon 
by the public than commodity speculation of this sort. In 
our recent period of unrest over the rising cost of living, 
much legislation and many administration measures were 
directed against devices of this sort. Nevertheless, loans 
to store goods are very essential to the marketing of many 
crops. The supply appears suddenly on the market, and if 
credit cannot be obtained by the grower, the crop must be 
sacrificed at depressed prices. The purchasers, presum- 
ably often in a better position to obtain bank capital, 
would then be in as good a position as the local dealer to 
withhold from sale for the sake of influencing the price 
unduly. Rejection of applications based on paper of this 
sort woula seem to create injustices as between different 
classes of grain dealers. 

It is obvious that the ideal solution would be for the 
Board to be guided by the existing situation in the market 
and not by any easily ascertainable fact of the paper. As 
long as the goods are not unduly obstructed in their flow 
to the market, the reserve advances appear to be justified. 
In the words of the Board, the test is whether the funds are 
requested in order to facilitate the orderly and regular 
marketing of the crops. Thus in the Bulletin for December 
I, 1919,^ we read of certain remarks addressed to cotton 
growers : 

The Board has consistently advocated during the past five 
years the policy of orderly marketing of crops. Assuming that 
adequate warehousing facilities are available, it seems to be in 
the interest of the consumer as well as of the producer that staple 
commodities remain as far as possible in the hands of producers 
until sold for consumption. This policy gives the producer the 
benefit of an average price in that he is not required to "dump" 

» Page 1 109. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 91 

his products upon the market in excessive volume, thereby 
depressing the price to the advantage of favored consumers or 
of speculators who do not as a rule pass the advantage on to the 
consumer. Owing to the great number of producers there will 
always be competition between them to sell, which would not 
be the case if large syndicates were able to acquire control of the 
bulk of the crop. 

But no matter how wide the difference in results between 
speculative borrowing and those necessary for the orderly 
moving of the crops, the determination of the precise situa- 
tion can never be easy. The eligibility of any single note 
must depend upon general market and business conditions. 
Under some situations the note of a grain dealer should be 
accepted; under other situations the note of the same 
dealer for an identically similar purpose must be rejected. 
Day-to-day considerations must govern. 

V^hat help can be obtained by following through another 
criterion ? Were the proceeds originally employed in order 
to purchase goods in form fairly complete, or close to the 
point where marketable? Or, on the other hand, were the 
proceeds invested in goods which must be completely 
altered in form in order to render marketable? If this be 
the basis of distinction, the reserve funds must render less 
aid to the production and industrial than to the distribu- 
tive interests of society. Coal purchased by a gas company 
is not to be marketed until completely altered in form. 
Labor purchased by an electric light company emerges in 
salable condition only in form of electric current. But 
might not the note of the gas company be just as liquid 
when the proceeds are used to purchase coal as the note of 
a grain dealer to secure funds for acquiring grain? Is not 
the pay-roll expense of the electric light company as 
speedily contributory to income as the expenditure of the 
grocery dealer for canned goods? The labor employed is 
not sold, but the products speedily are. It is evident that 



92 FEDERAL RESERVE POLICY 

little aid is to be obtained by focusing attention upon the 
form of the goods purchased by the proceeds of the note. 

Shall another criterion be accepted — the speed with 
which the borrower should be able to liquidate his loan? 
Shall it be the shortness of the period within which the 
expenditures bring in returns which determines eligibility? 
Should reserve funds be withheld from operations, in all 
other respects as commercial as any other, in which for 
technical reasons a longer period than ninety days is 
required? It is evident that such a course would involve 
much partiality. As stated in the Bulletin for June i, 1915 : * 

There are many processes of production which take a longer 
time than 90 days, and while no Federal Reserve Bank should 
enter into an agreement for the renewal of discounted paper, 
nevertheless, in cases where the ''process of production" dis- 
tribution covers a period longer than 90 days, there is no reason 
why a borrower should not renew his 90 day borrowing. 

In general, as stated in another connection, "Liquidity should 
not be tested by standards that are too narrow, arbitrary or 
inflexible." 

It thus appears that no one yardstick is available in 
determining the eligible character of the paper offered for 
rediscount. Neither liquidity, nor existence of a contract 
to sell the product, nor the form of the goods acquired by 
the proceeds of the borrowing, nor the probable speed of 
liquidation, alone, is sufficient. Distinction between eli- 
gible and ineligible paper must often depend upon mere 
matters of degree or emphasis. Differences are often only 
relative. It is pertinent to inquire, therefore, whether in 
the original act it was not somewhat futile to place so much 
emphasis upon the commercial character of the paper. Are 
the distinctions between commercial and non-commercial 
paper too difficult to employ consistently in practice? 
Should discriminations have been waived and certain 

' Page 74. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 93 

types of investment paper rendered admissible? Queries 
such as these must be postponed until a later chapter. But 
this much is now clear : under the present regulations much 
reliance must be placed upon the discretionary judgment, 
first of the member bank, second of the reserve bank direc- 
torate, and lastly of the Federal Reserve Board. If this be 
true, it appears desirable to inquire whether other means of 
restricting the unwise use of reserve bank facilities were 
contained or should have been contained in the statute. 

One obvious method of preventing excessive use of 
reserve funds would be to limit the amount of rediscounts 
obtainable by any one member institution. Since all mem- 
ber banks contribute to the resources of the reserve banks 
according to their capital and surplus, their rediscounting 
privileges might be determined on the same basis. In this 
way an outside limit could be placed on the extent to 
which any one bank could rely upon the reserve facilities, 
and any one bank could be prevented from using funds 
so excessively as to diminish the power of reserve banks 
to render aid to other member institutions in periods of 
emergency. 

Such a restriction did not commend itself to the framers 
of the act. It is true that another statute^ prevents a 
national bank from incurring certain indebtedness in excess 
of its capital stock. But to the application of this law there 
are certain exceptions. One of these exceptions ^ relates to 
any indebtedness incurred under the provisions of the Re- 
serve Act. It has accordingly been ruled that a member 
bank may rediscount paper to any amount permitted by the 
district directorate. It was felt that in periods of emergency 
the power of the district board to render relief should not 
be curtailed. In periods of business confidence, it was 

» Section 5202 of the Revised Statutes. 
' See section 13, Federal Reserve Act. 



94 FEDERAL RESERVE POLICY 

believed that most reliance should be placed upon the 
good judgment of the district bank directorate. Restric- 
tion of rediscounts for any one bank is accordingly a matter 
of the discretionary power of management. 

A second plan would be to restrict the amount of redis- 
countable paper bearing the signature of any one party. 
Such a limitation might appear to be much more equitable. 
Should one borrower of one bank be refused accommoda- 
tions at a time when the paper of another no more deserv- 
ing borrower of another bank is admitted? Should not 
discriminations take account of facts of justice between 
individuals, rather than primarily between banks? Acting 
on this pointof view, the framers of the statute prohibited the 
rediscount of paper bearing the signature of the same name, 
provided such paper exceeds ten per centum of the unim- 
paired capital and surplus of the lending bank. To this 
general statement exceptions are to be made in case of 
"bills of exchange" drawn in good faith against actually 
existing values. Furthermore, in order to encourage the 
purchase and acquirement of war securities an act of lim- 
ited duration was enacted, according to which, on April i6, 
1919, the Board ruled it permissible for a reserve bank to 
rediscount paper of a single borrower to an amount equal- 
ing twenty per cent of the capital and surplus provided the 
excess above ten per cent was secured by a like face amount 
of Liberty bonds or certificates of indebtedness.^ 

But would the paper of any borrowing individual redis- 
counted with the reserve bank be included within the 
limitations of section 5200 of the Revised Statutes. 
Would the creditor be considered to be the member bank 
or the reserve bank? In view of the fact that rediscounts 
must be endorsed by the member bank, and accordingly 
comprise a contingent liability of the bank, a good case 

^ Cf. Commercial and Financial Chronicle, April 19, 1919, p. 1561. 



ADVANCES OF RESERVE BANKS— REDISCOUNTS 95 

would seem to exist for regarding them in this light. But 
by an Opinion of Counsel it was ruled in the Bulletin for 
September 1,1918, that: ' 

A note or bill rediscounted in good faith by a member bank 
which is no longer owned or held by the bank need not be in- 
cluded as a liability of the maker to the bank within the meaning 
of section 5200, Revised Statutes. 

The effect of this opinion is to confirm the view that 
rediscounting offers a process by which a bank may increase 
greatly its loans to any one client. In case the paper of any 
one borrower approaches the ten per cent limit, such 
paper may be rediscounted. In this case it becomes an 
obligation, not to the member, but to the reserve bank. 

A consideration of these various limitations perhaps 
justifies this general conclusion : provided a member bank 
possesses a sufficient quantity of rediscountable paper, 
effective limitation of the rediscounts must depend almost 
solely on the good judgment of the district directorate and 
the Federal Reserve Board. Restraints of a direct nature, 
arbitrary refusals to accept the applications of certain 
classes of paper, depend largely upon the reserve director- 
ates. Indirect restraint, those relating to the cost of redis- 
counting, depend ultimately upon the Board, because of 
its power to review rates of rediscount. The development 
of the reserve system is thus largely a story of manage- / 
ment. Statutory provisions reduce themselves in large 
measure to the discretionary judgment of direction. The 
most important restrictions relate to the prohibitions on 
speculative and investment paper. But for the most part 
the Board's rulings and regulations have been exceedingly 
liberal. 

It was not contemplated by the framers of the act that 
reserve banks should lend their facilities to non-member 

* Page 867. 



96 FEDERAL RESERVE POLICY 

institutions. These banks were not rendered subject to 
examination by the Federal Reserve Board and make no 
contribution to the capital of the reserve institutions. To 
rediscount this paper must destroy, one of the principal 
incentives to membership in the Federal Reserve. 

What, however, was enacted about indirect means of 
securing the use of reserve funds? Could not the member 
bank accept the paper of non-member institutions and by 
rediscounting this paper free its own resources? In this 
way the reserve could be made the indirect source of 
advances to non-member institutions. 

It was felt by the lawmakers that this would be a situa- 
tion necessitating much discrimination in judgment. On 
some occasions it might be a service to member banks for 
reserve banks to aid non-members in this indirect way. Such 
action might be the means of restoring general business 
confidence. In other situations, however, such advances 
might not be necessary and might have the sole effect 
of discouraging membership in the system. Accordingly, 
the law requires that, in case the purpose of such applica- 
tions was to secure funds to reloan non-member banks, the 
permission of the Federal Reserve Board must be obtained. 
During the war period, however, matters of Government 
finance were deemed sufficient to warrant a very liberal 
application of the statute. For a certain period it was left 
to the discretion of the district bank directorates to deter- 
mine whether such accommodations should be afforded the 
non-member institutions.^ 

» Cf. Bulletin, June i, 1917, p. 426. 



CHAPTER V 

DIRECT COLLATERAL ADVANCES TO MEMBER 

BANKS 

When the Federal Reserve system began operations in the 
fall of 1 9 14, advances could not be made, under the author- 
ity of section 13, by direct discounts of member banks' 
notes. Leaving out of account their open-market opera- 
tions, reserve banks could grant accommodations only 
upon the tender of paper which had originated previously 
in an advance by the member bank to one of its clients. 
In other words, the reserve bank's portfolio would consist 
of paper, the makers of which were the customers of the 
member bank. For the sake of ensuring the safety of this 
paper and accordingly of the soundness of the reserve 
banks' assets, member banks were required to endorse the 
paper offered for rediscount. But the member banks' re- 
sponsibility was contingent and not direct. 

The reasons motivating the lawmakers to discriminate 
against direct discounts were several. In the first place, the 
paper accepted would be single — and not double-name. 
Only the member bank would be responsible for ultimate 
payment ; whereas in the case of a rediscount, the member 
bank's contingent responsibility would be additional to 
that of the original borrower. Secondly, rediscounting 
operations emphasized more strongly the direct public 
benefits which the reserve system was intended to accom- 
plish. In case of a direct discount for a bank, it might be 
difficult for many to understand just how the business pub- 
lic was being aided ; whereas in the case of a rediscount the 



98 FEDERAL RESERVE POLICY 

ability of a bank to finance a specific transaction would 
seem to depend more directly upon the willingness of the 
reserve bank to accept such paper. Rediscount operations 
appeared to bring the reserve banks more closely in con- 
tact with the public. Finally, it was feared that direct 
advances might be dangerous. If the member bank pos- 
sessed short-time eligible paper, it could secure aid through 
rediscounts ; in case it possessed no such paper, its purpose 
very likely would be to secure capital for long-time com- 
mitments. To refuse to make direct advances would not 
seem to penalize the institution which held paper of the 
eligible sort. But it would penalize the bank whose assets 
consisted largely of investment or speculative paper. 
Applications for direct discounts would be the resource of 
those institutions which did not possess eligible paper, and 
whose assets, therefore, were presumably, non-liquid. 

Of these various objections, the last was apparently the 
most impressive. For one illustration we may quote the 
following extracts from the reply of John Perrin, Chairman 
of the San Francisco Reserve Bank, to the appeals of the 
Orange County Bankers' Association of California for an 
amendment to the act which would permit direct discounts 
of member banks' paper:' 

Bank reserves under requirements of the old system were at 
times found inadequate and financial panic resulted. Your 
resolution seems to us to advocate not only a continuance of the 
evils of the old system, but, in advocating loans of Indifferent 
liquidity out of diminished reserves, urges a further weakening. 
It would seem to us that no policy could be more suicidal and 
none more certain to involve both the banks and their custom- 
ers in disaster. . . . 

The development of liquid commercial paper is a fundamental 
essential of banking progress. In lowering reserve requirements 
the Federal Reserve Act contemplates that a bank's paper 

» See Commercial and Financial Chronicle, January 22, 1916, p. 300. 



COLLATERAL ADVANCES TO MEMBER BANKS 99 

eligible for rediscount with Federal Reserve bank will consti- 
tute an important part of its real reserve. This fortification 
your resolution would sweep aside, though it should be clear 
that while the Federal Reserve bank may convert shortly matur- 
ing liquid paper into means of payment it has no power to con- 
vert a non-liquid loan into one which will speedily convert itself 
into a money reserve. 

If direct discounts should be made to members who did 
not possess the necessary amount of eligible short-time 
paper, the truth of the above statement would be clear. 
But might not a member bank desire frequently to offer 
its own note even though its portfolio did contain liquid 
admissible paper? Might not a bank find direct discounts 
more convenient and feasible? An affirmative answer to 
this query might be based on the following grounds : 

(a) The member bank might wish to borrow for very 
short periods of time. To discount customers' paper of 
longer maturity would subject the applying bank to the 
heaviest discount applying to the paper with longer matur- 
ity. Rather than submit to this heavier charge, the coun- 
try bank, in particular, might continue to seek aid from 
its city correspondent instead of applying to the reserve 
bank. Such action would render it all the more difficult for 
the reserve system to extend its membership and improve 
its prestige and power to regulate the money market. 

(b) In the second place, it was argued that direct dis- 
counts would reduce greatly the labor of computing inter- 
est on many small notes. Discounts would have to be 
figured only on the member's note; when this note fell 
due, it could be paid off and the collateral, consisting per- 
haps of customers' paper of various maturities, could be 
returned. 

(c) In the third place, direct advances collateraled by 
customers' notes could be made to offer some margin of 
security to the reserve bank. The face value of the collat- 



100 FEDERAL RESERVE POLICY 

eral could be made higher than the amount of the advance. 
In the case of an uncollateraled rediscount, there could be 
no margin of security over the advance of the reserve 
bank. 

With the lessons of experience thus indicating that di- 
rect discounts, properly regulated, could be supported by 
arguments relating to safety as well as to those of conve- 
nience, a general demand arose for a change in the statute. 
Accordingly, on September 7, 19 16, an amendment to the 
Reserve Act was passed according to which such advances 
were to be permitted in cases where the member bank's 
note was limited to fifteen days' maturity and in cases 
where the collateral consisted either of the kind of paper 
eligible for rediscount or of Government securities. The 
specific wording of this amendment was as follows : ' 

Any Federal reserve bank may make advances to its member 
banks on their promissory notes for a p)eriod not exceeding 
fifteen days at rates to be established by such Federal reserve 
banks, subject to the review and determination of the Federal 
Reserve Board, provided such promissory notes are secured by 
such notes, drafts, bills of exchange, or bankers* acceptances 
as are eligible for rediscount or for purchase by Federal reserve 
banks under the provisions of this Act, or by the deposit or 
pledge of bonds or notes of the United States. 

The reasons for the inclusion of the several restrictions 
on direct collateral advances should be clear. Unless the 
objection of rendering the reserve assets more non-liquid 
was to hold, member banks should possess paper of an 
eligible sort. If they held such paper, it would be no hard- 
ship to require them to forward it as collateral for the ad- 
vance. The basis of limiting the maturity of the member's 
note seems obvious, likewise. If the previous difficulty 
was need of funds for a period shorter than the maturities 

» See section 13 of the amended act. 



COLLATERAL ADVANCES TO MEMBER BANKS loi 

of customers' paper, member banks could not object to 
the limitation of fifteen days for the period of advance. 

After the date of the amendment, the advantages of 
direct borrowing frequently proved appealing aside from 
considerations of convenience. In the seven months or so 
preceding the outbreak of hostilities, the reserve adminis- 
tration continued to stress, as a means of preparation for 
any future emergency, the desirability of maintaining the 
liquid character of the reserve system's assets. Fifteen- 
day paper accordingly was much in demand by the reserve 
banks. After the outbreak of the war, direct loans collat- 
eraled by Government securities rendered great aid in the 
Treasury's war finance policy. Prior to September 7, 19 16, 
member banks which might have acquired Government 
bonds could not liquidate them by means of rediscount 
operations. It is true that customers' paper, the proceeds 
of which had been used to purchase Government bonds, 
was eligible. But in the Treasury's war finance campaign 
it proved necessary frequently to rely heavily upon the 
subscriptions of the member banks themselves. To guar- 
antee banks against loss through the fact that the bond 
subscriptions might temporarily drain them of funds, mem- 
ber banks were permitted to discount their own notes col- 
lateraled by Government war securities at very low rates. 
On May 25, 1917, for instance, a special rate of from two 
to four per cent was established at the New York Reserve 
Bank for member banks' one-day collateral notes arising 
from the Government's loan operations. This was raised 
to three to four and one-half per cent on December 7,1917.^ 

For these reasons the use made of the direct collateral 
advance was great. For the years 1917-20 inclusive the 
amount of such operations was as follows:^ 

* Cf. Report of the Federal Reserve Board for 19 17, p. 37. 
' Figures were compiled from the Report of the Federal Reserve Board for 
various years. 



102 



FEDERAL RESERVE POLICY 



Year 


Member Banks Collateral Notes 
Accepted by Reserve Banks 


Total Amount of Bills 
Discounted 


1917 

1918 

I919 

1920 


$ 7,742,806,186 
33,007,788,230 
72,548,007,733 
55.565.447.000 


$ 8,968,990,818 
39,752,933.847 
79.173,969,730 
85,320,874,000 



The direct collateral loans thus came to constitute by 
far the most important form by which advances were made 
by Federal Reserve banks to member banks. The great 
bulk of these loans were secured by United States certifi- 
cates of indebtedness and Liberty bonds. This is indicated 
by the following figures : ' 



Year 



I917 
1918 

1919 

1920 



Member Banks Collateral Notes 
Secured by War Paper 



Total Amount of Direct Col- 
lateral Loans to Member Banks 



$ 5,884,160,624 
32,142,405,711 
72,289,834,393 
55,410,876,000 



$ 7,742,806,186 
33,007,788,230 
72,548,007,733 
55,565447,000 



The amount of reliance placed by member banks upon 
the direct collateral loan after the fall of 19 16 cannot be 
stressed too highly. In the first place, after the first issue 
of Government war securities in 19 17, we hear no more 
about the inability of member banks to take advantage of 
the reserve system's rediscount facilities because of the 
lack of eligible paper. Practically every member bank 
possessed at some time or other considerable quantities of 
war paper. This sort of an advance, moreover, rendered it 
easy for the Treasury to carry out its easy-money policy 
of financing the war. As long as member banks could re- 
discount their own notes thus collateraled at rates approxi- 
mately equal to the rates borne by the bonds, and as long 

* Figures were compiled from the Report of the Federal Reserve Board for 
various years. 



COLLATERAL ADVANCES TO MEMBER BANKS 103 

as the reserve banks continued to announce their policy 
of cooperating with the Treasury, they need stand in no 
great fear of over-subscribing to the war issues. The key 
to the abiUty of the Treasury to float billions of dollars 
of bonds at a low interest rate lay in the ability of mem- 
ber banks to obtain funds on easy terms from the re- 
serve banks. Permitting the notes to be collateraled by 
Government securities virtually offered an additional 
means by which funds could be obtained from the Federal 
Reserve. 

Direct advances also rendered it far easier for the banks 
to carry customers who employed borrowed funds to pur- 
chase the war bonds. In case the customer should not com- 
plete his payments and the bond should revert to the bank, 
the bank could liquidate, at least temporarily, by relying 
upon the reserve bank. In large measure the apparent ease 
with which the Treasury obtained a market for its issues 
can be attributed to this amendment of September, 19 16. 
In opposite fashion, whatever evils resulted from the easy- 
money policy of war finance can likewise be attributed 
largely to the working of this amendment. 

It is true that advances of this sort were limited to bor- 
rowings of fifteen days' duration. Nevertheless, the Fed- 
eral Reserve administration was very liberal in its renew- 
als. The only limitation was that the reserve bank must 
not obligate itself to make such renewal.^ Such an agree- 
ment might create the situation in which the maturing 
note would be paid off out of the proceeds of the new dis- 
counts, and the fifteen-day limitation be virtually sus- 
pended. But if the requirements of the bank should be due 
to the emergency character of the general financial situa- 
tion or to its own liberal subscriptions, there was little 
doubt but that faith could be reposed in the ability to 
» See Opinion of Counsel, Law Department, Bulletin, October i, 1917, p. 765. 



104 FEDERAL RESERVE POLICY 

obtain such renewals. To quote from the Opinion of 
Counsel of the Board : ^ 

If, however, the Federal Reserve Bank is under no such agree- 
ment and has the option to require payment in cash, it may at 
the maturity of a 15-day note discount another for the same 
amount, secured by the same or substituted collateral, so long 
as the two transactions are independent of each other. 

The question of how far this practice should be encouraged 
by Federal Reserve Banks is one of policy rather than law. It 
may be reasonably assumed that the Federal Reserve Banks 
will not permit its abuse. 

' See Opinion of Counsel, Law Department, Bulletin, October i, 1917, p. 765. 



CHAPTER VI 

THE DEVELOPMENT OF THE TRADE ACCEPTANCE 

In the earlier days of reform-discussion there was a sharp 
difference of opinion regarding the necessity of a new bank- 
ing structure. On the one hand, it was argued that despite 
many imperfections of detail the national banking system 
would not so frequently have failed to function adequately 
had there existed in this country a strong controlling 
bankers' bank. It was insisted that such an institution, by 
compelling credit-restraint in the years of excessive activ- 
ity, and by making its resources easily available in time of 
emergency, could do much to prevent the periodic collapses 
of the credit structure. This school admitted it was un- 
fortunate that our note issues were based upon the public 
debt; that our reserves for bank deposits were rigidly 
defined at law and improperly employed by the metropoli- 
tan financial institutions; that the peculiar credit needs of 
foreign trade industries had been so largely overlooked. 
Such difficulties as these were admittedly serious; but, 
nevertheless, it was insisted that a central bank of even 
moderate resources could do much to moderate the inten- 
sity of our credit ills. The major defect was held to be 
decentralization in reserve holdings, in note issues, and in 
control. 

A second school, however, endeavored to formulate the 
tenet that no new banking structure was required or was 
even desirable. In view of the prevailing hostility to the 
idea of a central bank, it would be futile politically to 



io6 FEDERAL RESERVE POLICY 

endeavor to devise a dominating bankers' bank. Rather, 
reform measures should proceed on less ambitious lines. 
Instead of retaining rigid reserve requirements for depos- 
its, we should provide for elasticity by the employment of 
a graduated tax on deficient reserves ; note issues should be 
based on the general commercial assets of a bank rather 
than upon its holdings of Government bonds; foreign 
trade difficulties should be corrected by bestowing addi- 
tional powers upon national banks such as the right to 
accept bills and drafts for international commerce pur- 
poses. Finally, as a matter of very great importance, many 
improvements could be wrought in our commercial paper 
and trade credit usages. In particular, the attempt could 
be made to increase the use in commercial transactions of 
two-name trade paper. 

As the controversy progressed, however, these two 
schools of thought became less sharply differentiated. On 
the one hand, it came to be more widely perceived that a 
central bank might encounter serious difficulties unless 
reserve requirements were rendered less rigid ; note issues 
less inelastic; commercial paper less unsound. On the 
other hand, it was gradually recognized that the adminis- 
trative . development of many proposed reforms would 
require the sponsorship of a large dominating central 
institution. In particular a more liquid type of commer- 
cial paper could be popularized only by a propaganda 
more effective than any private agencies without power to 
act could conduct. Was not this the teaching of past finan- 
cial history? Despite the admitted evils of earlier trade 
credit methods, the privately controlled banks had failed 
to develop a wide open market for sound commercial 
paper. The only hope of improvement lay in the forma- 
tion of a strong central institution with power to guide and 
influence. 



DEVELOPMENT OF TRADE ACCEPTANCE 107 

Viewed in this light, the campaign for double-name 
commercial paper becomes one of the most prominent 
aspects of the reform begun in 19 14. The Federal Reserve 
banks were not to be solely discount institutions; they 
also were to be the sponsors and the leaders in the propa- 
ganda for more sound methods of commercial banking. 
In this respect was realized the special contribution of a 
man who played a peculiarly important role in banking 
progress. Prior to 19 13 Paul M. Warburg was closely 
identified with credit-reform, and after the passage of the 
Owen-Glass Bill he was a member of the first Federal 
Reserve Board. The life of his work survived many 
changes of political and legislative control. During the 
period of preparation of the Aldrich Bill, his contribution 
to the publications of the National Monetary Commission 
was The Discount System in Europe. In this work the main 
contrast between European and American banking meth- 
ods was asserted to be no more the lack of a central bank 
here than that 

The European financial system is constructed upon discounts 
as its foundation; the American system is constructed upon 
stocks and bonds as its foundation. ' 

The especial virtue of the European credit mechanism was 
that its ''discount system mobilizes the resources of the 
banks. "^ Further: 

The discount and central bank system enables the Nation to 
meet these situations by concerted but varying action adjusted 
to meet each individual case. ^ 

The historical causes of present methods of trade credit 
are now generally understood. Prior to the Civil War the 
bill of exchange, drawn by the seller against the buyer, was 

^ Page 23. 
' Page 39 
3 Page 37. Italics are the writer's. 



io8 FEDERAL RESERVE POLICY 

commonly employed. The bill, when accepted, would be 
discounted at the seller's bank. In this way the seller 
rendered liquid his trade assets; the seller's bank commonly 
had available a supply of easily negotiable commercial 
paper; and the buyer endeavored to conduct his opera- 
tions in such a way as to ensure his ability to meet his 
obligations on the promised date. 

Gradually, however, this custom was superseded by the 
open book account system coupled with the offer of a lib- 
eral discount for prompt cash payment. This change in 
methods is explained by the writers as due largely to two 
causes.^ First, the fluctuating value of the dollar in the 
greenback days rendered tradesmen anxious to close their 
accounts as soon as possible. Many of them began to offer 
large discounts to ensure early payments. Since it would 
not do to obligate the buyer to pay on a future date, his 
indebtedness would be carried currently as a book account. 
In this way, two-name trade paper became less and less 
common. To acquire the funds for his remittance the 
buyer would offer his banker his own single-name note. 
Control over trade credit has passed more and more from 
the hands of the wholesaler's bank and has been lodged in 
the hands of the local banker. If the buyer did not remit 
promptly, the seller might be obliged to obtain a line of 
bank credit. But the paper of the seller was his own single- 
name, and did not evidence any particular transaction. 

We are also informed, as a second explanation of the 
change in trade credit methods, of the development of the 
work of the traveling salesman in such a way as to alter 
the legal position of the buyer. When the retailer selected 
from the stock of the wholesaler as in the earlier days and 
had an opportunity to examine the quality of the goods, 

^ Cf., for Instance, E. E. Agger, "The Commercial Paper Debate," Journal of 
Political Economy, July, 1914, pp. 663-67 



DEVELOPMENT OF TRADE ACCEPTANCE 109 

the legal doctrine of caveat emptor prevailed. But when 
he bought from sample, he had a right to insist that the 
goods conform to the quality of the sample. Before ac- 
knowledging his indebtedness he must have an opportu- 
nity to inspect the goods. He prefers to be carried on the 
books in the meanwhile and consequently objects to 
accepting immediately a draft. 

But despite these facts it seems difficult to account for 
the extremely great scarcity of good two-name trade paper 
in 1 9 14. It would seem as if the demand on the part of the 
bank with surplus funds to invest would have created at 
least a limited field for this type of paper. It would seem 
reckless to assert that the requirements of the capitalist 
were absolutely impotent. 

Answers to this query may be had, however, by noting 
the type of transactions to which paper similar in form to 
the bill of exchange was customarily employed. The draft 
had been relegated in trade transactions largely to the 
slow accounts. It was employed in many cases because 
the seller had become so suspicious regarding the buyer's 
ability to pay or so impatient at his delay that he demands 
a definite acknowledgment of the buyer's obligation to 
remit on a definite date. Two-name commercial paper was 
in bad company. 

Some difficulty, moreover, was experienced frequently 
in the collection of two-name paper. The drafts were 
usually not made payable at any bank specified by the 
buyer of the goods. In this respect its position differs 
somewhat from that of the modern trade acceptance. Under 
the Negotiable Instruments Law, recognized in a large 
majority of our States, a trade acceptance made payable 
at a specified bank operates in the same manner as a check. 
Upon maturity, if presented for payment, it will be charged 
to the account of the buyer provided there are sufficient 
funds to meet it. 



no FEDERAL RESERVE POLICY 

Banking facts, also, help to explain our inability to 
develop good two-name trade paper. For various reasons 
there existed no broad open market, upon which the bank 
could depend confidently for the sale of its short-time 
commercial paper. With a strong central bank in exist- 
ence, directed from the standpoint of public needs, there 
should not have been the same difficulty in time of emer- 
gency of liquidating upon holdings of such paper. Since 
the time of Andrew Jackson, however, no such institution 
had existed in this country. It seemed preferable, there- 
fore, in establishing a secondary reserve to invest in securi- 
ties for which the stock exchanges furnished continuous 
quotations. This was the basis of Warburg's remark, pre- 
viously quoted,^ that ''the American system is constructed 
upon stocks and bonds as its foundation." 

Finally, unlike the currency systems of most continental 
European countries, our banking law placed no premium 
on commercial paper as a basis for note issues. The bond- 
secured note issue has much for which to answer. 

If, then, it was generally agreed in 19 13 that the Federal 
Reserve must assume a large measure of responsibility for 
the development of an improved type of trade paper, what 
were the pertinent provisions of the original statute? It 
has been stated previously that, while the matter was con- 
sidered seriously, the lawmakers refused to designate two- 
name trade paper as the sole type eligible for rediscount. 
By the terms of section 13, reserve banks were given the 
right to discount any of the following: "notes, drafts, and 
bills of exchange arising out of actual commercial trans- 
actions." Eligible paper was to depend, therefore, upon 
the nature of the underlying transaction and not upon the 
form of the paper. The concessions of this section (number 
13) are confined to certain permissions for the rediscount 

^ See supra, p. 107. 



DEVELOPMENT OF TRADE ACCEPTANCE iii 

of a larger amount of paper bearing the signature of one 
party than in the case other types of paper are offered. 
This matter will be discussed briefly toward the close of the 
chapter. 

It is in the open-market section (number 14) that we 
find the principal concession to trade paper. Reserve 
banks are empowered to purchase ''from member banks 
and to sell, with or without its indorsement, bills of 
exchange arising out of commercial transactions." This 
constitutes an evident discrimination in favor of two-name 
trade paper, since nowhere is the promissory note included 
in the permissible class of open-market investments. De- 
spite these concessions, however, statutory recognition of 
two-name trade paper is so limited that its later develop- 
ment must be credited largely to the discretionary acts of 
the reserve administration. 

Before investigating the trade paper policy of the reserve 
administration, it may be desirable to recall some of the 
advantages urged in behalf of encouraging the use of a 
proper type of the commercial bill of exchange. These 
supposed advantages have been heralded so widely and 
discussed so generally that we shall attempt to do no more 
here than to mention them briefly. These advantages may 
be classified as falling under three heads: first, those of 
special concern to the seller of the goods; second, those 
addressed primarily to the buyer; and, lastly, those ap- 
pealing most directly to the self-interest of the banker. 

To the seller the arguments were based on the oppor- 
tunity of securing almost immediately upon the sale of the 
goods a definite agreement of the buyer to pay on a certain 
date, an agreement, moreover, which is couched in nego- 
tiable form. Much preferable, therefore, is it to the uncer- 
tain and unadmitted obligation of the buyer as evidenced 
only by the seller's book records. Bad debts and slow pay- 



112 FEDERAL RESERVE POLICY 

ments must be lessened by the encouragement of such 
paper. If payments of the purchaser are speeded up, the 
bank borrowings of the seller need not be nearly so great ; 
and the cost of securing working capital is reduced, a fac- 
tor, moreover, which competition must gradually cause to 
redound to the benefit of the public. But even if no speed- 
ing up of payments is induced, trade paper may still per- 
mit the seller to liquidate his assets more quickly. The 
book accounts of the seller, ordinarily, were difficult to 
assign. Requests for borrowed funds on the basis of such 
assigned accounts were interpreted frequently as evidence 
of the faulty financial position of the seller. Because such 
assignments were in general disuse, such requests were 
frequently interpreted as evidence of the impaired finan- 
cial standing of the applicant. The accepted draft of the 
buyer, drawn at the time of shipment, should prove much 
more negotiable, and therefore enable the local banker to 
make advances even though his own ability to continue to 
hold the acceptance is doubtful. In other words, the wider 
the market for commercial paper, the greater the ability 
to liquidate trade assets quickly. 

It has proved somewhat more difficult to convince the 
buyer of the advantages to be derived by the substitution 
of trade paper for the open account. It is true that it was 
easy to argue that any system which would render more 
certain to the seller the redeemability of his payments re- 
ceivable must gradually through the force of competition 
lessen the charges exacted by the seller. But would it secure 
immediately, in the specific transaction in hand, and with 
relation to his own competitors, any cheaper terms? It 
must be borne in mind that the average buyer makes one 
transaction at a time and is only indirectly interested in 
improving methods employed by trade as a whole. Too 
often the propaganda has confused general and long-time 

/ 



DEVELOPMENT OF TRADE ACCEPTANCE 113 

advantages with those of special and immediate interest 
to the buying business man. It may be true also that the 
trade acceptance method may serve to check reckless buy- 
ing on the part of the purchaser. But must it not be 
difficult to convince any one purchaser that his buying 
habits are so loose as to necessitate his obligating himself 
to make payment on a specific, definite date? Clearly, 
arguments to the purchaser have greater force when the 
appeal is based upon specific individual advantages in the 
particular transaction in which his acceptance is requested. 

Arguments of immediate individual advantage might 
be the following : In the first place, the buyer who agrees 
to obligate himself definitely regarding the time of pay- 
ment improves his credit position with his banker. Often a 
query of the banker is this — do you accept trade drafts? 
An affirmative answer may raise the buyer's credit rating.^ 
It is to be admitted, of course, that the underlying expla- 
nation of this discrimination is to some extent artificial. 
The motive of the member banks in encouraging the 
acceptance frequently has been their desire to secure a 
type of paper rediscountable with the Federal Reserve at 
a low, preferential rate. But whatever the source of dis- 
crimination, it has been made to apply with increasing 
force. In some industries, firms which accept trade drafts 
have been able to insist upon better terms as regards cost 
of goods and quantity obtainable. These firms could 
advance the argument that the acceptance enables the seller 
to obtain his bank credit at a cheaper rate. Frequently 
also the acceptance offered a means by which the small 
and comparatively unknown firms were able to place 
themselves more largely upon a position of credit equality 
with those of a more firmly established credit standing. 

The advantages of trade paper could also be heralded to 

' Certain exceptions to this statement will be discussed later in this chapter. 



114 FEDERAL RESERVE POLICY 

the commercial banker. It has been remarked that in the 
past it was customary in the slack seasons for the interior 
banks to invest in large volume surplus funds in the secur- 
ity market or to place them on deposit with their corre- 
spondents in the financial centers. In recent years the work 
of the note broker had so developed that it was compara- 
tively easy to find an outside market for these surplus 
funds by investments in short-time commercial paper. 
But the ability in an emergency to liquidate such paper in 
advance of the date of maturity was a factor of doubt. 
Commercial paper investments, sufficiently attractive so 
far as yield was concerned, did not make a good secondary 
reserve. The limited open market for such paper explains, 
therefore, in large measure the huge volume of commercial 
bank funds regularly invested in the bond market or rede- 
posited with the financial institutions in the stock market 
centers which bid for such funds. 

The danger of these practices was called to the public's 
attention forcibly in the panic of 1907. The call of the inte- 
rior banks for New York funds and the general attempt 
to liquidate quickly on security investments soon caused 
a general suspension of payments in our financial center. 

But correction of this difficulty was not easy. Crisis 
and financial panics are not ordinarily contemplated as of 
inevitable recurrence. A change from old methods could 
be induced only by establishing in normal times a wide 
open market for commercial paper. The market should be 
so broad and steady as to offer the same means of liquidat- 
ing assets as those furnished by bank redeposits and bond 
investments. Here was the place for the trade acceptance. 
It was two-name, had its origin presumably in an automat- 
ically liquidating commercial operation, and with proper 
backing from reserve authorities could be converted into 
cash on occasions of real need. 



DEVELOPMENT OF TRADE ACCEPTANCE 115 

It was accordingly possible to make for the acceptance 
an appeal to all classes of the business public. As to the 
means which must necessarily be employed to increase its 
use, it has been stated previously that these depended 
largely upon the discretionary power of the reserve admin- 
istration. It was not a matter of slavish devotion to the 
terms of the statute. Favorable discrimination was con- 
fined by the act to the provisions relating to open-market 
operations and to those bearing upon the amount of redis- 
countable paper bearing the signature of any one party. 
It is therefore necessary to inquire next as to the precise 
means employed by the reserve management to extend 
the use of such paper. 

In circulars issued November 16, 1914, and April 2, 
191 5, the Federal Reserve Board outlined certain special 
privileges and preferential rates of discount to be enjoyed 
by the acceptance. But the trade acceptance as a distinct y 

class of commercial paper dates its origin to the issuance of 
Regulation J, Series of 191 5. By this regulation the name, 
** trade acceptance," is devised for double-name commer- 
cial paper which conforms to certain requirements. The 
intention was to find a means of distinguishing this new 
type of commercial paper from other paper, similar in 
form, but lacking some of its essential characteristics. For 
instance, the trade acceptance would be similar in form to 
a draft arising from other sorts of transactions than those 
purely commercial. To deserve the title of "trade accept- 
ance" and to enjoy the special privileges which it was 
proposed to grant it, the paper must conform to the follow- 
ing qualifications : First, it must be drawn by the seller of 
the goods against the buyer. Second, it must be drawn on 
account of the indebtedness created by the transfer of the 
goods and for no other reason. Third, it must be accepted 
by the buyer under conditions whereby the date of pay- 



Ii6 FEDERAL RESERVE POLICY 

merit is made certain. When presented to a reserve bank 
for discount, such paper must bear the endorsement of a 
member bank, and must have a maturity at time of redis- 
count of not more than ninety days. Evidence of the 
nature of the underlying transaction could consist of a cer- 
tificate to the effect that "The obHgation of the acceptor 
of this bill arises out of the purchase of goods from the 
drawer." If it so desired, the district directorate could 
inquire into the exact nature of the basic operation. 

A perusal of the terms of this regulation will suggest the 
answer to the query as to why this favored class of paper 
must be made out solely in the form of the draft. Would 
not a promissory note for the amount of the goods ten- 
dered to the seller by the purchaser possess the virtues 
desired for the trade acceptance, namely, that the paper 
be double-name and that it arise out of an operation of 
commerce? Discrimination in favor of the draft depended, 
not on belief that the form of the paper proves the nature 
of the operation, but upon the belief that a trade transac- 
tion can ordinarily be proved more readily when the paper 
is in the form of a draft. In case of the draft the seller and 
not the buyer takes the initiative in making out the trans- 
action. The buyer may postpone so long the making out 
of the note that it might be difficult to determine which of 
a series of operations was financed by any one piece of 
paper. The draft lends itself readily to the requirement 
that proof of the transaction be available at the time the 
paper is presented to the banker. If desired, the bank can 
insist that the bill of lading and other shipping documents 
be attached to the note which is offered for discount. 

What success has been realized in the endeavor to popu- 
larize such paper? Complete and accurate information 
regarding this matter is difficult or impossible to obtain. 
Some indication of the use of this paper may be had by 



DEVELOPMENT OF TRADE ACCEPTANCE 117 

examining the discount operations of the reserve banks in 
such a way as to compare the amount of trade acceptances 
discounted to commercial paper of all classes. Figures are 
not given for open-market operations, since the volume of 
these reflects too greatly the volition of the reserve man- 
agement. What we need to obtain is information indica- 
tive of the holdings of member banks.^ 





Trade Acceptances Dis- 


Total of all Classes 


Percentage of Trade 


Year 


counted FOR Member 


OF Discounted Paper 


Acceptances to all 




Banks 




Classes of Dis- 
counted Paper 




In Thousands of Dollars 




1920 . . 


, $192,157 


$85,320,874 


.2 


1919 . . 


138,420 


79,173,970 


.1 


1918. . 


. ; 187,373 


39,752,934 


•4 


1917.. 


37,771 


8,968,990 


.4 


1916. . 


5,212 


207,870 


2.5 



These figures do not indicate any such startling growth 
in the use of trade acceptances as to suggest a sudden and 
complete revolution in trade credit methods. Of course 
the nature of reserve bank operations does not portray 
with exactness the condition of member bank portfolios. 
But the larger the amount of acceptances held by member 
banks, the greater the probability that the proportion of 
this paper discounted to that of other classes will be large, 
and vice versa. But in one way these figures may not do 
exact justice to the acceptance. In the earlier years of 
reserve operations the trade acceptance was discountable 
at a lower rate than other classes of paper. Later this 
preference was eliminated. At no time, however, was 
there a rate discrimination against the trade acceptance. 
And the general conclusion derived by examining the fig- 
ures is confirmed by the prevailing type of literature upon 
the subject. A very large portion of it attempts to explain 

* Figures are obtained from th^ Annual Reports of the Federal Reserve Board. 



ii8 FEDERAL RESERVE POLICY 

the nature of the difficulties encountered in the endeavor 
to secure its popularization. Let us next, therefore, at- 
tempt to state some of the obstacles which stood in the way 
of a wide extension of its use. 

A first difficulty was the easily explained hostility of 
many of the stronger firms in various industries. Many 
such hesitated to encourage the use of a new instrument 
which tends to place their smaller rivals on a position of 
credit equality. In Warburg's words:' 

When borrowing on its own note, the strong firm, with well- 
established credit, can obtain larger loans and on more favor- 
able terms than its small competitor, and it is, therefore, in 
position to finance its purchases and its sales on a more favor- 
able basis than the small firm. It gains the advantage both as 
to the larger scope of business it can do and the lower interest 
rate it enjoys. True, it could probably do a larger business than 
at present by adopting the trade acceptance plan, but by thus 
adopting the trade acceptance basis small firms would probably 
profit more In proportion than the larger ones; their handicap 
would be lightened. 

It is necessarily more difficult to secure an inroad for 
the acceptance by appealing to the smaller establishments. 
Their customs and methods are not studied so thoroughly 
by the trade as are those of their larger rivals. The lead 
must be taken by the leaders. And it could not be expected 
that weaker establishments, those with a very low credit 
rating, could be led easily tojseize the opportunity of 
removing their credit disadvantage by adopting the accept- 
ance. These weak firms object to binding themselves to 
pay on a definite date. Moreover, there has been no desire 
on the part of the acceptance propagandists to make this 
type of paper the resort of the weak firm. No paper can 
classify more highly than the standing of the obligee. 

Much difficulty has also been experienced in converting 
« From address published in part in Bulletin, July, 191 8, p. 605. 



DEVELOPMENT OF TRADE ACCEPTANCE 119 

the commercial banker to the new method. To quote 
Warburg again : ^ 

Some bankers assert that in buying a promissory note the 
mere fact that they are conscious of buying the naked note 
of a customer furnishes a reason for their feehng obHged to 
carefully analyze the statement of the customer and to judge 
the merit of the borrower upon the statement of the latter 's 
financial condition. They allege that this practice is safer than 
that of purchasing a trade acceptance issued by the same firm, 
because, as they say, in that case they are likely to rely on the 
legitimate character of this double-name paper without examin- 
ing as cautiously as they otherwise would the general condition 
of the borrower. 

The answer to this view has been stated previously. 
Bankers who purchase acceptances should examine the 
financial condition of the parties as carefully as when dis- 
counting a single-name promissory note. It never was 
contemplated that a change in the form of paper would 
eliminate the necessity of such examination. Such a result 
would be an unfortunate by-product of the trade accept- 
ance movement. 

Some firms which employ the trade acceptance are 
obliged frequently to borrow on their own single-name 
note. A question which confronts the banker in such situa- 
tions is whether the use of the acceptance in other trans- 
actions impairs the quality of this paper. Some bankers 
have answered this question in the affirmative by announc- 
ing their reluctance to buy the single-name paper of a 
borrower who practices the sale of his trade acceptances.^ 

The reason given for this view is that whoever buys a trade 
acceptance acquires the first lien on what would otherwise have 
represented one of the accounts receivable of the concern which 
drew the acceptance, and in addition to that lien, in case of 

' From address published in part in Bulletin, July, 1918, p. 604. 
'Ibid. 



120 FEDERAL RESERVE POLICY 

bankruptcy of the drawer of the acceptance, the holder of 
that acceptance would rank equally with the unsecured note 
holder as a general creditor for any part of the acceptance which 
the acceptor might not have paid. 

The answer to this contention has already been indi- 
cated. Examination and financial analysis are as necessary 
as in the case of the unsupported single-name note. With 
proper care this objection should not hold. Unless its 
privileges are abused, the practice of accepting should 
improve the borrower's credit rating. It implies a willing- 
ness to meet obligations on a definite date and a desire to 
avoid buying in excess of ability to pay. 

All in all it appears that the reserve management has 
been amply justified in lending its aid to the trade accept- 
ance movement. But the moment special privileges are 
granted, new difficulties arise. Inevitably attempts are 
made to create a paper, similar in form to the trade accept- 
ance, but for purposes not contemplated by the reserve 
administration. Unless such attempts are checked, the 
distinctive place of the trade acceptance as an easily 
liquidated type of commercial paper is lost. 

One of these objectionable methods has been to employ 
it in old accounts. Because of the greater proportion of 
bad debts, in such cases it would not have been surprising 
had the Board ruled that the draft thus drawn did not con- 
form to its conception of the trade acceptance. The Board 
might have ruled that the draft must be drawn only at the 
time of the transfer of the goods. But in this matter the 
Board's ruling was liberal. In an Informal Ruling we read : ^ 

A bill drawn by a retail dealer on his retail customer to finance 
the sale of goods to that customer is a trade acceptance within 
the meaning of the Board's regulations, even though it is drawn 
after the purchaser has failed to remit promptly on an open 
account. 

' BuUetin, January, 19 18, p. 30. 



DEVELOPMENT OF TRADE ACCEPTANCE 121 

But even though such drafts might be held technically 
admissible, it is suggested, as a matter of not subordinating 
"the trade acceptance to the open account by suggesting 
it as a last resort for bad debts," that reserve banks 
"should be encouraged to discriminate against them as far 
as possible. ..." 

In the minds of some, doubt existed as to the status of 
the trade draft on occasions when the purpose of the buyer 
was not to resell the goods, but to use them for some other 
purpose. The argument against the admission of these 
drafts would be that such use destroys their character as 
paper automatically redeemed out of the sale of the goods. 
Aside, however, from the difficulty of ascertaining the 
facts in each case, such a limitation might confine the 
acceptance too largely to the field of distribution and ren- 
der it more difficult for the manufacturer and producer to 
derive advantage through the development of this new 
type of trade paper. On strictly logical grounds, moreover, 
it might not make so much difference whether the goods 
were to be resold. They might be used in such a way as to 
aid the purchaser in the sale of other goods. They might 
assist in increasing the liquidation of other goods. 

But the basic transaction must be real and not ficti- 
tious. Various subterfuges are attempted frequently to 
enable the drawing of the drafts, which are then paraded 
as bona fide acceptances. One of the more common of 
these devices is the formation of subsidiary sales corpora- 
tions which act as the acceptors of the drafts. In reality 
the transaction may not involve even the transfer of goods 
from one department of the business to another. Such 
bills come close to classifying as those in which the drawer 
makes out the draft against himself. 

In another connection the status of a bill, which in effect 
was drawn by the drawer against himself, was stated in an 



122 FEDERAL RESERVE POLICY 

opinion of M. C. Elliott, then Counsel of the Federal 
Reserve Board:' "In substance such an instrument is a 
promissory note, single-name paper and no more." But 
subsidiary corporations, subsidiary though they be, pos- 
sess an independent corporate life. Would, then, a "draft 
drawn by a lumber corporation upon a sales corporation 
which it and a number of other lumber concerns have 
organized . . . when accepted, become a trade accept- 
ance, even though the selling corporation is a stockholder 
of the sales corporation "?^ 

The opinion of counsel in this case was couched in very 
general terms. The status of the paper would depend upon 
the purpose underlying the existence of the sales corpora- 
tion. Such paper could be classified as trade acceptance 
paper if the sales corporation was organized in good faith 
and not merely as an agent of the selling corporation, to 
evade the law. Such a conclusion would follow logically 
from the acceptance of the premise that the transaction 
must display evidence of some real progress in the process 
of manufacture, production, or distribution. The transfer 
of goods from a corporation to a mere agent or subsidiary 
might not be an essential step in hastening the goods in 
their journey toward the ultimate consumer, even though 
the buying corporation did possess an independent corpo- 
rate life. 

Another difficulty concerned the use of the trade accept- 
ance in renewals. It is clear that, if merchants should 
develop the practice of taking new bills in renewal for 
those maturing, the distinctive quality of trade acceptance, 
a bill quickly redeemable out of the sale proceeds, would be 
destroyed. Such a renewal trade draft would be much 
akin to that arising in the settlement of past-due accounts. 

» Bulletin, September i, 1916, pp. 462-63. 
» Ibid., January i, 191 8, p. 33. 



DEVELOPMENT OF TRADE ACCEPTANCE 123 

Accordingly we find the American Acceptance Council 
insisting that 

if an extension of the credit is given, it should be in the form of 
a promissory note with interest.^ 

Opinions vary considerably regarding the extent to 
which the acceptance has been thus employed. Regarding 
this matter the American Acceptance Council states : ^ 

So far as we have learned, however, these practices have been 
largely, if not entirely, confined to houses of minor importance, 
and they were possibly not surprising in view of the period of 
credit strain which was endured last summer and autumn, 
particularly in the textile lines, regarding which the complaints 
were most general, and the ignorance or lack of appreciation 
among the smaller and less well-informed commercial concerns 
as to the proper use of the trade acceptance. A flabblness of 
commercial moral fibre may also have been a contributing cause. 

These were a few of the difficulties encountered in the 
endeavor to win for the acceptance a reputation as the 
purest type of commercial paper. Continuous vigilance 
was necessary to prevent misuse. But problems of policy 
also arose which retarded its rapid development. One of 
these related to the number and strength of the firms 
whose allegiance to the acceptance should be sought. 

In this matter the financial administration was con- 
fronted with two alternatives. Either the acceptance must 
be pushed zealously among all firms indiscriminately, 
irrespective of their credit standing, and for multitudinous 
sorts of transactions; or, the propaganda must be begun 
slowly and cautiously, confining its use to firms with high 
credit rating and for bona fide commercial transactions. 
The latter was the only feasible policy. Little improve- 
ment over former methods would have been achieved by 
the adoption of the acceptance in all types of transactions. 

* Cf. Commercial and Financial Chronicle, April 2, 192 1, p. 1345. 
» Ibid. 



124 FEDERAL RESERVE POLICY 

In fact, the trade acceptance presented some grave ele- 
ments of danger if its use became general. One of these — 
over-buying — may easily arise in situations where the 
banker neglects to take the usual precautions of examina- 
tion. This depends upon the fact that the trade accept- 
ance is, in form, readily negotiable. Many illustrations of 
this danger were presented in the crisis of 1920-21. Some 
receiverships were explained as due to over-buying encour- 
aged in just this way. When the seller hesitated to tie up 
more funds by sales on credit, he would be requested to 
continue to ship goods, taking in payment an acceptance, 
which, it was argued, could be discounted easily. The very 
liquidity of the trade acceptance created the temptation 
to sell in excess of the normal volume. When the crisis 
came, many firms were caught with excessive stocks on 
their shelves and in their warehouses. 

It is true that a more conservative bank-credit policy 
would have served to check such excessive activity quite 
irrespective of the sort of trade paper available. But the 
trade acceptance rendered it easier for the banks to fur- 
nish the unsound credits. Bankers had to be impressed 
again and again with the fact that nothing in the nature of 
the acceptance justifies refusal to take due precautions 
regarding the analysis of the credit standing of the parties 
to the bill. It appears, therefore, fortunate that the propa- 
ganda has proceeded slowly and cautiously, that in the 
beginning the main campaign was begun among the strong, 
representative firms in lines of industry where the accept- 
ance was expecially applicable. It would have been a mis- 
take, perhaps irretrievable, to have tried to encourage its 
use among firms of poor credit rating. Care also had to be 
taken not to push the acceptance too rapidly into indus- 
tries where the buyer would interpret its use as a reflection 
upon the soundness of his financial standing. 



DEVELOPMENT OF TRADE ACCEPTANCE 125 

With this brief discussion of the difficulties of extending 
the use of the acceptance, we may now be prepared to offer 
a more conclusive answer regarding the necessity of a cen- 
tral banking system in our credit structure. Experience 
seems to have proven that, no matter how great may be 
the advantages ultimately obtainable from the use of the 
acceptance, a rapid increase in its use would have brought 
many evils. Despite the encouragement of an active propa- 
ganda and of a preferential rate of rediscount, the trade 
acceptance to-day is employed relatively infrequently. 
Without a strong central institution to foster its use by 
rediscounts and direct purchase, its sound growth must 
have been even less rapid. No small part of its present 
attainments is due to the belief that the reserve banks were 
ready to employ their funds if necessary in the acquire- 
ment of the acceptances of prime quality. 

A final query yet remains for brief consideration. What 
limitations exist regarding the amount of trade accept- 
ances discountable by member and reserve banks? Let us 
first consider the matter of limitations applicable to the 
member banks in their discounts for their clients. 

It will be recalled that section 5200 of the Revised 
Statutes limits the amount of advances to any one person, 
firm, or corporation to an amount not exceeding ten per 
cent of the bank's capital and surplus. But to this general 
statement there are certain exceptions. Among these is 
"commercial or business paper actually owned by the per- 
son negotiating the same." It has been held that this 
exempts the trade acceptance, since it classifies as paper of 
this sort. To quote from an Opinion of Counsel in the 
Bulletin: ^ 

... a trade acceptance negotiated in good faith by the bona 
fide owner would be exempt from the limitations of section 5200 
' October i, 19 18, p. 974. 



126 FEDERAL RESERVE POLICY 

as "commercial or business paper actually owned by the person 
negotiating the same." 

But what is the situation with respect to the amount of 
trade acceptances permissible for rediscount by a reserve 
bank? Section 13 of the act limits the amount of paper 
bearing the name of any one borrower to an amount equal 
to ten per cent of the member bank's capital and surplus. 
But an exception to this statement is made by the follow- 
ing clause : 

This restriction shall not apply to the discount of bills of ex- 
change drawn in good faith against actually existing values. 

The decisive question relates to the question of when a 
bill will be considered as drawn against ** actually existing 
values." Here there are two possibilities: first, when the 
bill is discounted before acceptance; second, when dis- 
counted subsequently to acceptance. 

Before accepted by the buyer, the bill could not be 
interpreted as being properly secured by the personal 
obligation of the buyer. Actually existing values must 
then be proved by the goods themselves. Unaccepted bills 
do not form an exception to the general provision unless 
title can be shown to the goods. To quote from an Opinion 
of Counsel in the March i, 191 7, Bulletin: ^ 

A bill of exchange discounted before acceptance may be said 
to be drawn against actually existing value, within the meaning 
of section 13 of the Federal Reserve Act, when and only when 
it is accompanied by shipping documents, warehouse receipts, 
or other papers securing title to the goods sold. 

An accepted bill, however, may be considered as drawn 
against actually existing values 

if drawn against the drawee at the time of, or within a reason- 
able time after, the shipment or delivery of the goods sold. 
» Page 195. 



DEVELOPMENT OF TRADE ACCEPTANCE 127 

[But] In this latter case there must be reasonable grounds to 
believe that the goods are in existence in the hands of the drawee 
either in their original form or in the shape of the proceeds of 
their sale. 

Bills accepted before sale or delivery of the goods could 
not be treated as drawn against actually existing values, 
however, unless the goods have been placed in storage 
under the order of the drawee. Such goods would not be in 
the possession of the drawee in original form or in the 
shape of the proceeds of the sale. The essential commer- 
cial nature of the transaction would then be lacking. 



CHAPTER VII 

AGRICULTURAL CREDIT UNDER THE FEDERAL 

RESERVE 

It has long been recognized that the credit needs of the 
agricultural classes differ widely from those of the purely 
commercial or mercantile interests. Among other charac- 
teristics agricultural credit needs are relatively long-time, 
and are subject to pronounced seasonal variations. It 
might have been expected, accordingly, that a special set 
of institutions would have been evolved in this country to 
obtain capital from the investment public for agricultural 
purposes. For the most part, however, these institutions 
have been undeveloped here, and the national banking 
institutions with which the farmer has dealt have been 
patterned more in accordance w^ith the needs of commerce 
and distribution. Mercantile and distributive credit 
requirements are far different from those of agriculture. 

Justification for the restrictions relating to real estate 
loans in the National Banking Law, however, was easy to 
establish. In most part these restrictions were the result 
of past disasters which developed when bank funds were 
employed to promote excessive land speculation. From 
the standpoint of logic, also, the desirability of limiting 
loans on real estate security seemed clear. Since the great 
bulk of the deposits of the national banks are demand 
deposits, should not institutions whose obligations are 
payable on call be required to keep their assets liquid? 
Had not past experience proved the slowness of real estate 
paper? At any rate, these restrictions were a part of the 
National Banking Law. 



AGRICULTURAL CREDIT 129 

It has sometimes seemed difficult to account for the 
marvelous development of an industry thus handicapped 
in its borrowing facilities. Explanation is twofold. First, 
credit has been obtained largely from other sources; 
second, the farmer's past credit needs were relatively 
limited. Land was cheap and farming could be begun with 
a limited amount of equipment. As cultivation was con- 
ducted on a more and more intensive scale, new capital 
was required, but this was supplied largely out of past 
profits. Farming was creating in large measure its own 
funds for extensions. The industry was seasonal in its 
nature, but during the slack seasons employment was fur- 
nished by the work of further clearing, building erection, 
extension of the cultivated area. Goods were brought on 
time from the local merchant, and, although the price 
paid for this sort of credit has undoubtedly been high, the 
farmer has been somewhat slow to perceive that the cost 
of credit emerged in the price exacted for the goods. 

Gradually, however, the dependence of the farmer upon 
the bank, even for short-term credit, has become more 
intense. Farm machinery is costly, and the amount 
required by modern methods is increasing. The horse is 
beginning to give away to the tractor; this is an era of the 
automobile, motor truck, gasoline engine, steam plough, 
artificial fertilizer, and blooded live stock. Between 1900 
and 19 10 census figures show a per-acre increase in the 
value of farm implements and machinery of 61.8 per cent. 
Development of new land has become more difficult with- 
out credit aid. Very little cheap and easily cultivated land 
is now available; farm-land extension has necessitated 
expensive methods of cultivation, such as dry-farming and 
irrigation. At the same time education and propaganda 
have become more and more convincing in regard to the 
high cost of credit obtained indirectly from the store- 



130 FEDERAL RESERVE POLICY 

keeper. Under the store lien system the farmer obtaining 
credit obliges himself to sell his goods through the store- 
keeper. He obtains customarily low prices on his sales and 
pays very high prices on his supplies. In an article on 
agricultural credit Professor E. W. Kemmerer quotes Mr. 
George K. Holmes, of the United States Department of 
Agriculture, as follows:^ 

The rate of interest on the liens on the cotton crop of the 
South, it is safe to say, probably averages 40 per cent a year. 
All cotton men will agree that it is at least that. The store sys- 
tem of the South is a sort of peonage ; that is what it amounts 
to with the cotton planter. 

With similar experiences elsewhere, the desirability as well 
as the necessity of drawing more largely upon the commer- 
cial bank became apparent. 

The growing needs of bank credit granted, we may next 
inquire as to the ability of existing institutions to supply 
it. Attention has already been called to the provision of 
the National Banking Law limiting loans on real estate 
security. But State bank restrictions were usually not 
onerous. It was often not so much a matter of the legal 
impossibility of making the credit advance as of the finan- 
cial undesirability to the banker of the farmer's paper. As 
previously mentioned, agricultural credit of necessity must 
be relatively long-time. The farmer is engaged in a pro- 
ducing activity ; not until he has a product in salable form 
is he in shape to make repayment of the loan. A note 
drawn to obtain funds for the purchase of cattle or seed- 
grain cannot be redeemed out of the sale proceeds until 
sufficient time has elapsed for the cattle to be fattened or 
for the grain to become the harvested crop. The farmer's 
operations are much more akin to those of the manufac- 

' Cf, E. W. Kemmerer, "Agricultural Credit in the United StSites," Anterican 
Economic Review, December, 1912, pp. 852-72. 



AGRICULTURAL CREDIT 131 

turer than to those of the retailer, jobber, or wholesaler. 
Three months is ordinarily a very short maturity for the 
average farmer's note. 

It should be borne in mind that it may be much more 
hazardous for the farmer to depend upon renewals than 
for the retailer or wholesaler. It may be inconvenient for 
either of the latter to have their notes called. But a forced 
sale, by marking down prices, is usually possible. Goods 
unsold exist presumably in salable form. Not until after 
the harvesting season, however, is the farmer in possession 
of readily marketable goods. 

But is it legitimate for the farmer to depend upon the 
commercial bank for such credit needs? Has he a right to 
insist that the commercial bank supply capital not return- 
able in a very short period? The answer is several fold. 
Many of his needs are for purposes much more quickly 
and easily liquidated than the sort of advances which in 
the early days created the prejudice against real estate 
loans. Then our difficulties arose in the purchase of land 
before cultivation was practicable. Loans for the purchase 
of machinery or cattle are far different in character. But 
irrespective of all this, the commercial bank supplies much 
more capital to the merchantile interests for developmental 
purposes than is ordinarily supposed. The stock and bond 
investments of the commercial bank have been enormous. 

But at any rate the commercial bank may be the only 
institution available for the farmer. He cannot offer his 
stock or bonds to the investment public through the in- 
strumentality of the bond house. Neither have there been 
perfected here cooperative credit institutions for the pur- 
pose of appealing to the investing public. In Europe, by 
way of contrast, such associations have accomplished 
much. Details of their organization vary. But usually the 
plan involved the acquirement by the society of the mort- 



132 FEDERAL RESERVE POLICY 

gages on the property of the members who desire advances. 
On the basis of these mortgages, the society offers its 
paper to the public. The investor is thus protected by the 
collective security of the members' obligations. But in 
America orgainzations had not even developed to such an 
extent as to preserve for the agricultural borrower funds 
saved by members of his own class. Savings bank invest- 
ments, built up in part from farmer's deposits, have been 
made customarily in corporate bonds of industrial enter- 
prises. In the course of time such institutions as the Land- 
schaften in Germany may take root here. But sudden 
development cannot be expected. In the meanwhile the 
commercial bank must be organized to offer legitimate 
credit aid to the farmer. 

Not only are the farmer's requirements long-time ; they 
are also subject to pronounced seasonal fluctuations. 
Banks which commit their funds to industrial undertak- 
ings in the off season may find themselves unable to take 
care of the farmer during the busy spring-planting or fall 
crop-moving period. Deposits with banks in the financial 
centers could normally be withdrawn without difhculty. 
But during the season of agricultural strain the security 
market might be temporarily low and render inadvisable 
liquidation of bond investments. Limitations on the 
farmer's ability to sell commercial paper in the open market 
already have been mentioned. The frequent preference 
of the banker for industrial rather than for agricultural 
clients may be traced in part to the unsteady credit appe- 
tite of the agricultural borrower. 

The special needs of the farmer understood, a next in- 
quiry was to ascertain the means by which relief could be 
granted. Everyw^here the hope was expressed that there 
should be a continued development of cooperative agri- 
cultural credit societies. But what role should the com- 



AGRICULTURAL CREDIT 133 

mercial national bank play in all this? Of course it was 
insisted that the legal restrictions of the National Banking 
Law be modified. It was asserted that the real estate loan 
limitations were driving business from national banks 
to State banks, and that attempts to avoid this loss of 
business explained many subterfuges and indirect methods 
of evading the terms of the statute. Frequently the stock- 
holders of a national bank would organize a State bank in 
the same building and under the same roof. The same set 
of officers would keep the books of the two institutions, 
direction would be harmonized, clients would be mutual. 
Only in one respect were they separate institutions, and 
that was in the fact of their separate corporate life. Bor- 
rowers on real estate mortgages would be "recommended '* 
to the "other" bank under the archway. To the extent 
that the law created subterfuges of this sort, the chief 
result was to lessen the size of the national banking system 
and add to the prestige of the State banks. 

It could also be argued that the restrictions of the law, 
in many situations, lessened rather than increased the 
soundness of national bank assets. National banks could 
not loan on real estate security, but were permitted to dis- 
count the unsupported note of a farmer. Before the matur- 
ity of the unmortgaged note, the borrower might execute 
a lien in another borrowing operation in favor of a State 
bank. In case of the insolvency of the borrower, the 
national bank's claim to the property would be inferior to 
that of the State institution. The national bank could 
have acquired a prior lien had it been permitted at the 
time of the loan to demand a mortgage. 

But one fact relating to the safety of farm loans seems 
strangely to have been overlooked by many students of 
agricultural credit. It is true that in the past some of our 
most severe crises were due to over-speculation in land. It 



134 FEDERAL RESERVE POLICY 

is also true that farm borrowings are for a relatively long 
period of time and that the commercial bank deposits 
should be protected by easily liquidated holdings. Still, in 
past depressions the speed with which agriculture has 
recovered often has been astounding. Poor years may 
come, markets or crops may fail, but the nucleus of the 
farm organization remains intact. It is the exceptional 
case to find the farm in a good agricultural district totally 
deserted and rendered destitute of equipment. It is seldom 
abandoned as may be the case in an unprofitably estab- 
lished factory or shop. And steadily land values have 
increased. The big drops in this country have been due 
usually to temporary speculative reaction and represent 
only momentary oscillations on a steadily ascending curve. 

These considerations should not be interpreted as an 
argument for the total removal of restrictions on real 
estate loans. The commercial bank must keep its assets 
in fairly liquid shape ; it cannot base its advances on ulti- 
mate prospects. But no large proportion of a bank's 
assets need ordinarily be liquidated suddenly. Would 
there not be justification, accordingly, for permitting to a 
limited extent investments protected by real estate 
mortgages? 

But what provisions should have been inserted in the 
Federal Reserve Act relating to agricultural credit? The 
reserve banks were to be bankers' banks to guarantee, 
particularly in periods of emergency, the redeemability of 
member bank assets. They were to be the ultimate reserve 
holding institutions of the country. It, accordingly, was a 
matter of absolute necessity that they maintain their own 
assets liquid. The paper discountable w^as to be of the 
short-time, automatically liquidating variety. What room 
would there be in the Federal Reserve Act for a provision 
rendering it possible for a member bank to lend on real 



AGRICULTURAL CREDIT 135 

estate security? Logically none, unless such paper were 
eligible for rediscount or direct purchase. A change in the 
law not concerning directly the operations of reserve banks 
should appear in the form of an amendment to the National 
Bank Act. Nevertheless, a provision of this sort did 
appear in the Federal Reserve Act. In addition to this 
modification of the previous legal difficulty regarding real 
estate loans, it would be expected that something would 
have been attempted in the way of removing the financial 
undesirability of agricultural paper. Accordingly, certain 
preferences are granted agricultural over other sorts of 
commercial paper in the rediscount operations of reserve 
banks. ' 

We may now quote the provisions of the Federal Reserve 
Act of special importance to the agricultural borrower. 
The most important provisions of the statute are three. 
The first of these, in section 24, is not related to rediscount- 
ing. The original act read as follows in this section : 

Any national banking association not situated in a central 
reserve city may make loans secured by improved and unen- 
cumbered farm land situated within its Federal reserve district, 
but no such loan shall be made for a longer time than five years, 
nor for an amount exceeding fifty per centum of the actual 
value of the property offered as security. Any such bank may 
make such loans in an aggregate sum equal to twenty-five per 
centum of its capital and surplus or to one-third of its time 
deposits and such banks may continue hereafter as heretofore 
to receive time deposits and to pay interest on the same. 

Then followed a statement to the effect that the Federal 
Reserve Board could add to the list of cities in which 
national banks would not be permitted to make loans. 
Except for this, this section is not related in any direct way 
to the reserve mechanism. 

This section was later amended. Under certain restric- 
tions banks in the permitted cities may make loans on real 



136 FEDERAL RESERVE POLICY 

estate as well as upon farm-land. Also, the bank advanc- 
ing the funds need not be situated within the same dis- 
trict, provided the real estate or farm-land is "located 
within one hundred miles of the place in which such bank 
is located." 

The second of the agricultural credit provisions is found 
in the rediscounting section, 13. Whereas eligible com- 
mercial paper must have a maturity of three months or less, 

notes, drafts, and bills drawn or issued for agricultural purposes 
or based on live stock and having a maturity not exceeding six 
months may be discounted in an amount to be limited to a per- 
centage of the capital of the Federal reserve bank, to be ascer- 
tained and fixed by the Federal Reserve Board. 

This is the most important concession to the special needs 
of the agricultural interests to be found in the act. The ac- 
complishments under this section later will be considered. 
The last of these provisions of special importance to 
agriculture is to be found in the amendment to the act 
bestowing upon national banks power to accept certain 
types of domestic bills and drafts. Since no specific prefer- 
ential treatment is hereby granted agricultural paper, it 
might not appear to warrant mention in a chapter devoted 
to agricultural credit. But the domestic acceptance should 
prove peculiarly useful in removing many difiiculties 
hitherto encountered in the marketing of farm crops. As 
will appear more clear later, the bank acceptance is a 
method whereby the client's bank is enabled to aid him to 
secure funds from other banks. If the local banker is tem- 
porarily without funds and cannot discount the applicant's 
note, it may agree to accept a draft drawn against it by 
the prospective borrower. This accepted draft may be 
peddled around the market and because of the financial 
standing of the acceptor should find a ready market. It is 
as if the local bank had guaranteed the note of the client. 



I 



AGRICULTURAL CREDIT 137 

The farmer is in peculiar need of reaching the outside 
investment market in some such way as this. The seasonal 
character of agricultural operations often creates a strain 
too severe for the local banker. But the farmer unassisted 
has no way of securing the use of idle funds available else- 
where. He cannot have his notes peddled over the country 
by the note broker. His standing in the investment mar- 
ket is not such as to permit this. In view of these facts it 
seems strange to the writer that the special applicability 
of the acceptance to the farmer's marketing problems so 
frequently has been overlooked. 

With these, the pertinent provisions of the statute, we 
may next inquire as to the agricultural credit policy of the 
reserve management. Has it adopted a liberal or illiberal 
policy in the administration of its duties? Inasmuch as a 
prime function of the Federal Reserve Board is to define 
eligible paper, we may first test its liberality by examining 
some of its most important decisions so far as these have to 
do with the admission of paper to the agricultural class. 
Undue strictness and conservatism would tend to restrict 
the willingness of member banks to make loans of needed 
maturity to the applicant farmers. 

A first problem had to do with the interpretation of 
these words of the statute, "based on live stock." A 
strict construction might have held ''based on live stock" 
to be synonymous with "secured by live stock." The 
Board ruled, however, that the farmer's note need not be 
protected by a chattel mortgage on the stock. ^ " Based on '* 
is thus made to refer to the purposes of the farmer's note. 
If the funds were borrowed in order to acquire the stock 
the stock comprises part of the assets of the farmer guar- 
anteeing his ability to pay. This ruling made possible.: 
accordingly, the employment of less red tape in the advance 
of funds to the farmer. 

* See Bulletin, June i, 19 15, p. 72. 



138 FEDERAL RESERVE POLICY 

A second interesting ruling related to the eligibility of 
notes given by farmers in payment for tractors to be used 
in agricultural operations. It is to be assumed, of course, 
that the tractors were not intended to be resold. The main 
question here was whether tractors were to be classified as 
a permanent fixed investment. If they were so classified, 
the farmer's note would not be rediscountable. It would 
appear as if much justification would exist for such a clas- 
sification. It is to be expected that the life of the tractor 
would extend over several seasons, and it could not be 
regarded as an expense chargeable to the revenues of any 
one season. Would not expenditures of this' sort correspond 
to those invested in permanent drainage improvements, in 
silos, and in buildings? 

The act, however, stipulated as eligible paper that 
based upon live stock. Would it be possible to show the 
similarity of tractor paper to that of live-stock paper? 
If the law was to be construed strictly, this would appear 
to offer the sole means of holding such paper agricultural. 
This means was seized upon by the Board. In the words of 
the ruling: ^ 

Horses and mules bought for farm work are purchased with 
several years' use in view, yet there can be no question that a 
note given by a farmer In payment of a pair of mules to be used 
in farm work, maturing within six months, is eligible as agri- 
cultural paper. Where tractors are used to supplement the work 
of horses or mules or are used altogether instead of these ani- 
mals, it seems to the Board that notes given by farmers for the 
purchase price of tractors, and maturing within six months, 
should be admitted to discount as agricultural paper. . . . 

Implement paper, however, would present a situation 
in which solution could not be found by stressing the 
similarity to live-stock paper. Very early the Board was 
compelled to decide between a wide and a narrow con- 

' Bulletin, April i, 191 8, pp. 309-10. 



AGRICULTURAL CREDIT 139 

struction of the act. Decision in this matter comes closer 
to indicating the desire of the Board to render as available 
to the farmer as possible the facilities of the reserve 
system. 
The Board admitted ^ that it was 

a very close question whether agricultural implements are to 
be considered as permanent improvements or as a part of the 
cost of operation. 

But as ground for liberality 

it must be considered that machinery of this kind is not of a 
permanent character. It wears out rapidly and in most cases 
has to be replaced within a comparatively short time, so that it 
may be assumed that a certain amount of money would be spent 
annually and regularly for the purchase and replacement of 
machinery of this kind. 

It seems to the writer that it is extremely doubtful 
whether in other situations so much stress would be placed 
upon the fact that capital expenditures may be distrib- 
uted fairly evenly over a series of years. Would a manu- 
facturer's notes be eligible for the purpose of constructing 
buildings in such a way as to keep the erection costs 
approximately equal from year to year? Would the equip- 
ment notes of a railroad company be eligible because the 
replacement costs for rolling stock might display yearly 
uniformity? 

Prophetic vision is not required to answer these queries 
in the negative. The real intent of the Board appears to be 
expressed in the following:^ 

As the Board by its regulations does not desire unnecessarily 
to restrict, but rather to encourage, the facilities to be given, as 
far as that may be done consistently with prudence, it would 
appear that the wider interpretation in this case should be 
given. . . . 

' Bulletin, February i, 19 16, p. 67. 

' Ibid. 



140 FEDERAL RESERVE POLICY 

Certainly in such cases the burden of doubt is not placed 
against the farm borrower. 

Would it make any difference, however, who was 
the presenter of the note for discount? Would the Board 
be obliged, for instance, to refuse to admit as agricultural 
the paper presented by a dealer, and insist that the maker, 
the farmer, must be the presenter of the paper? In case 
the farmer had given his note to the dealer, which note had 
been discounted, would eligible agricultural paper have 
been created? Or, since the facilities are granted to the 
dealer and not to the farmer, must it not be classified as 
non-agricultural paper? 

It is clear that the purpose of the act was to give "spec- 
ial facilities to farmers." ^ The question, then becomes 
this — How can these facilities best be granted? In cer- 
tain situations the farmer might be accommodated to 
advantage by encouraging the method of note-giving to 
the dealer. Such a note would be double-name, and very 
likely would be discounted at a cheaper rate than the 
farmer's own single-name note. The Board ought not to 
insist upon the more expensive means of financing agri- 
cultural operations. It ruled accordingly that to classify 
as agricultural paper, the maker of the note need not be 
the presenter.^ 

But let us return to other cases in which the question at 
issue was whether or not the expenditure was for fixed- 
capital or long-time developmental purposes. One im- 
portant problem was the classification of notes given for 
the purpose of draining and tilling farm-land. How liquid 
would such notes be? How soon would such expenditures 
contribute to increased farm revenues? Questions of this 
sort might well involve the amount of expenditures pro- 

' Bulletin, February i, 191 6, p. 67. 
»Ibid. 



AGRICULTURAL CREDIT 141 

portionately to the total farm investment. The Board's 
ruling, however, made the decision depend upon the nature 
of land. In its own language : ' 

cases may arise in the reclamation of swamp lands where such 
lands could not be treated as farm land until expensive drainage 
systems have been installed. In such case there is doubt of the 
eligibility of the notes, the proceeds of which are used for this ' 
purpose. Where, however, the land drained is already in use as 
farm land, the draining may be treated as incidental to the culti- 
vation of the land, and notes given for such purpose may be 
rediscounted as agricultural paper. 

The liberality of this ruling is easily apparent. Ques- 
tions relating to the amount of such expenditures and 
their nature, are not even to be raised. The only criterion 
is whether or not the land previously has been under culti- 
vation. But even in the case of cultivated land, if such 
operations as draining do not constitute permanent im- 
provements — fixed -capital expenditures, in other words 
— it is difficult to know what might be. Such paper may 
vary widely from the automatically liquidating variety. 

A similar sort of decision is raised in connection with 
farmers' paper arising in the purchase of dairy cattle. In 
one query to the Board it was stated "^ that the 

cows will be used as dairy cattle which will be retained for a 
considerable length of time ^ to produce milk, butter, cheese, etc., 
and that the loan is not made, strictly speaking, for the 
"breeding, raising, fattening, and marketing of live stock." 

Nevertheless, the Board held such paper agricultural, 
since ''live stock includes cows." 

It would have been very easy, however, to hold that 
dairy cows, to be held permanently, were not "livestock" 
within the meaning of the act. Live stock is ordinarily 

* Bulletin, August i, 191 8, pp. 743-44. 
« Bulletin, March i, 1916, p. 112. 
» Italics are the writer's. 



142 FEDERAL RESERVE POLICY 

sold when fattened. In this sense live-stock paper is auto- 
matically liquidating. Dairy cattle, however, may not be 
sold, but contribute to income slowly. Their present sell- 
ing price represents the capitalization of their future earn- 
ings. In reality, dairy cattle is as much a fixed-capital 
expenditure as that required to purchase a building which 
is to be rented, or a locomotive which is gradually to earn 
its own replacement cost. 

These are some of the more interesting and illustrative 
of the Board's rulings bearing upon the differentiation 
between agricultural and non-agricultural commercial 
paper. Our next query concerns the method of identifica- 
tion of agricultural paper. Has so much red tape been 
required in the process that the farmer is harassed? 

This question relating to implement paper was answered 
by the Federal Reserve Board, December 30, 19 15.' We 
may quote the following: 

The nature of the bill, the name of the acceptor, and the name 
of the drawer would probably indicate that a farmer was the 
purchaser and an implement dealer the seller of the goods. 
However, the purchasing member bank will have to satisfy 
itself in some satisfactory way that the bill is substantially 
of an agricultural character. A simple memorandum attached 
to the bill, stating that the bill was drawn in payment of agri- 
cultural implements, signed either by the acceptor or the drawer, 
would probably be considered sufficient evidence by the member 
bank and the Federal Reserve Bank. 

It will be recalled that by the terms of the statute the 
amount of agricultural paper purchased by a reserve bank 
could not exceed a certain percentage of its capital stock. 
The amount of this percentage was to be fixed by the 
Federal Reserve Board. Some light may be thrown upon 
the Board's attitude by noting the percentages thus estab- 
lished. In every case this percentage has been fixed at 
ninety-nine per cent. This appears very liberal, 

» Bulletin, February i, 1916, pp. 67-68. 



AGRICULTURAL CREDIT 143 

In still another way a ruling of the Board was such as to 
make more difficult charges that it was ultra-technical 
or bureaucratic in matters relating to farm credit. In an 
informal Ruling in the June, 1915, Bulletin,'^ it held that a 
member bank need not make an exhaustive inquiry as to 
the use of funds borrowed in order that the paper might be 
classed as agricultural. It need only satisfy itself that the 
primary purpose was agricultural. The agricultural char- 
acter of the paper would not be destroyed even if it 
should be established that part of the funds were em- 
ployed for the support of the borrower's family. 

So far as commerce and industry are concerned, the 
reserve system has never endeavored to regulate the inter- 
est or discount rates member banks might exact. In the 
marketing of farm crops, we find the sole exception. Dur- 
ing a portion of its life, reserve banks, in order to facilitate 
crop marketing, established a discount rate lower than for 
other classes of paper. But member banks could redis- 
count at this low rate only on condition that they would 
pass this advantage on to the borrower. The borrower's 
paper was not red iscoun table if the member bank origi- 
nally exacted a rate higher than a certain published maxi- 
mum. This was the special "commodity" rate. 

The establishment of a special commodity rate grew out 
of the endeavor of the reserve administration in the summer 
of 1915 to be prepared for any contingencies which might 
arise in connection with the marketing of the cotton crop. 
All were aware of the disaster which befell the South and 
the entire country the year previous because of the sudden 
cutting off, at the outbreak of the World War, of the 
European market for the South's most important article 
of commerce. Accordingly, a committee of the Board 
sought to inform itself in the summer of 191 5 regarding 

» Page 72. 



144 FEDERAL RESERVE POLICY 

conditions in that industry. It learned that the reduction 
in cotton acreage had been such that ample storage facili- 
ties were available in the South for the warehousing of such 
portion of the crop as might have to be carried over. Hav- 
ing ascertained that the physical means were at hand for 
the orderly marketing of the crop, it appeared that the 
special need was to ensure a sufficiency of bank credit to 
finance the carry-over. 

The committee entertained the view that warehouse receipts 
for cotton, grain, and other staple non-perishable agricultural 
products of a readily marketable character, form an excellent 
basis for bank loans. ^ 

Accordingly, on September 3, 1915, the Board issued regu- 
lations according to which notes secured by non-perishable 
staples receive the benefit of the low special rate. 

Since the Board was especially desirous that the advan- 
tage of this low rate should be passed on by the member 
bank to its customers, it was provided that only paper 
should be eligible for rediscount at the special rate upon 
which the member bank's charge was not more than six 
per cent per annum inclusive of all commissions. This 
special rate was not to be applied exclusively to cotton, 
but might serve for other staple commodities such as 
grain, cotton, and wool. The rate might be adopted by any 
reserve bank, and was not confined to any one district. 

To illustrate the manner in which credits might be 
granted, the following selection is quoted from a statement 
by the Secretary of the Treasury on September 3, 1915:' 

A borrower asks his local bank for a loan on his note, secured 
by warehouse receipts for cotton. If the bank is satisfied that 
the cotton is in a responsible warehouse, properly insured, and 
that the note is good, it may make the loan. If the local bank 

* Cf . Report of the Federal Reserve Board for 19 15, p. 7, 
^Bulletin, October i, 1915, p. 301. 



AGRICULTURAL CREDIT 145 

charges the borrower, a rate of interest, including commission, 
not exceeding 6 per cent per annum, it may indorse the note 
over to the Federal reserve bank of its district, and the Federal 
reserve bank may advance to the local bank the full amount of 
the loan. The rate of interest which the Federal reserve bank 
will charge the local bank will be sufficiently low, say 3 per cent, 
to enable the local bank to make loans at a rate of interest not 
exceeding 6 per cent per annum, and have a liberal margin of 
profit on such transactions. 

The principal problem relating to the applicability of 
this special rate was that of the definition of "readily 
marketable staples." By this phrase, the intent was 
merely to confine the use of funds obtained from the 
reserve bank to goods capable of being graded, and for 
which a wide market usually existed, a market not ultra- 
sensitive to changes in consumers' whims and tastes. In 
one ruling it was held that ^ 

Potatoes, properly graded and packed and stored in a 
weatherproof and responsible warehouse, as evidenced by its 
receipt, would undoubtedly constitute a readily marketable, 
non-perishable staple within the meaning of the regulation. 

Although the 

so-called commodity rate was established some time ago in 
order to give a preferential rate particularly to farmers during 
the crop-moving season ^ 

it was ruled that manufactured goods, such as cotton yarn 
and flour, were staples within the meaning of regulations 
dealing with this class of paper.^ But such manufactured 
goods must be non-perishable and have a wide ready 
market. 

They must be goods generally produced and well established 
in commerce, not an extraordinary or unusual commodity for 
which there is no ready market. 

' Cf. Bulletin, August i, 1917, pp. 614-15. 

^Bulletin, January i, 1918, p. 30. 

3 See Regulations for Series of 1915 and Bulletin, October I, 1916, p. 523. 



146 FEDERAL RESERVE POLICY 

The use made of the commodity rate is indicated by the 

following figures : ^ 

Septembers, 1915, to December 31, 1915 $10,315,000 

January I, 1916, to December 31, 1916 16,813,200 

January i, 1917, to December 31, 1917 11,244,271 

These figures display only limited reliance upon this 
special rate. In the Report of the Federal Reserve Board 
for 1915 we read the following:^ 

The effect of the commodity paper regulation was mainly 
anticipatory and protective. The certain assurance that what- 
ever funds might be necessary for the gradual and orderly 
marketing of the cotton crop would be available at moderate 
rates had an immediate and stimulating effect on sentiment. 

But as the cotton market improved after the fall of 19 15, 
and as general ease in the money market prevailed, it no 
longer seemed desirable to offer this special rate. Accord- 
ingly, we read in the Bulletin for January, 1918,^ that it 
was merged with the general commercial rate. The prin- 
cipal significance of the special commodity rate appears to 
the writer to consist of its indication of the friendly atti- 
tude of the reserve administration toward the credit needs 
of agriculture. 

Let us now consider the matter of the rate of rediscount 
on six-months agricultural paper with a view of comparing 
them with commercial paper rates of lesser maturity. On 
account of the many different rates, and the changes in the 
basis of classification from time to time, as well as the fact 
that differences existed between the rates of the various 
reserve banks, it would be onerous to endeavor to state 
these results in tabular numerical form. But the follow- 
ing observations may be made : 

^ Figures obtained from the Anntial Report of the Federal Reserve Board. 
'Page 8. 
3 Page 30. 



AGRICULTURAL CREDIT 147 

1. From November 16, 1914, to January I, I9I5» the 
six-months rate exceeded the rates on shorter maturities 
never by more than one half of one per cent. In many 
districts there was no differentiation on the basis of 
maturities. 

2. On January i, 1916, the average rate In the twelve 
districts on agricultural and live-stock paper maturing 
after ninety days was five per cent. The corresponding 
average for the twelve reserve banks on 61-90-day paper 
was 41/6 per cent. 

3. On January i, 191 7, the average rate on agricultural 
and live-stock paper maturing after ninety days was 4 7/8 
per cent; 61-90-day paper averaged 4.2 plus per cent. 

4. On January i, 1918, the average rate on 6-months 
paper was 5.1 per cent. Corresponding average on 61-90- 
day paper was 4 5/8 per cent. 

5. On January i, 19 19, the average rate on 6-months 
agricultural paper was 5.27 per cent. The corresponding 
average on 61-90-day paper was 4.79 per cent. 

6. On January i, 1920, the average rate on commercial 
and industrial paper maturing within ninety days was 4.79 
per cent. The rate on 6-months paper was 51/8 per cent. 

7. October 31, 192 1, the average rate on ninety-day 
plus paper was 5 2/3 per cent. Corresponding rate on 90- 
day paper was the same. 

8. At no time has agricultural paper been discriminated 
against as such. The only discrimination has been that 
due to the length of the maturity. Agricultural paper 
maturing within ninety days has been discounted at the 
same rates as other commercial paper. Part of this period, 
a preferentially low rate of discount was available to the 
member bank offering a certain type of commodity paper. 
There has been displayed no hostility against the agricul- 
tural interests in the Reserve Board's rate policy. 



148 FEDERAL RESERVE POLICY 

With this conclusion reached regarding rates, it becomes 
\/ difficult to convict the Federal Reserve Board of any fail- 
ure to recognize the legitimate needs of agriculture. In 
many cases it has been shown that the definition of eligible 
agricultural paper has possibly been something more than 
fair. Bureaucratic methods of identification and certifica- 
tion have been conspicuous by their absence. At one 
period, agriculture, by means of the special commodity 
rate, was given a special low rate under conditions whereby 
a maximum rate was fixed for member bank charges. 
Liberality was displayed finally by the Reserve Board in 
determining the percentage of each reserve bank's resources 
which might be invested in member bank's six-months 
agricultural or live-stock paper. Unfairness to agriculture 
must, if it existed at all, have occurred by means of direct 
methods employed by the district directorates. By direct 
methods we refer to the refusals of these directorates to 
accept for discount or purchase good eligible paper from 
the member banks. Let us next ascertain, so far as is possi- 
ble, the extent to which agriculture may have encountered 
hostility in this manner. ^ 

The period in which to search for this hostile discrimina- 
tion must be that of 1 921 -21, the years of deflation in 
agricultural prices. Nobody accused the reserve manage- 
ment of illiberality in the earlier years. Until the war 
period the chief concern of the reserve management seems 
to have been to secure more complete employment for 
reserve funds. During the war period and for a year fol- 
lowing the armistice, credit expansion proceeded at an 
unexampled rate. What, then, does the evidence show 
regarding the relative treatment of agriculture and other 
industry in the years 1920-21? 

In the Bulletin for August, 1921,^ Governor Harding, of 

« Pages 895-99. 



AGRICULTURAL CREDIT 149 

the Reserve Board, in a letter to Senator Owen gives cer- 
tain figures bearing upon this matter. Some of these may 
be quoted: 

On July 9, 1920, the total bills on hand at all Federal reserve 
banks amounted to $2,934,184,000. On July 6, 192 1, this total 
amounted to $1,832,499,000, a decrease of $1,101,685,000. . . . 
The total of agricultural, commercial, and live-stock paper on 
hand, rediscounted for member banks, on July 6, 192 1, was 
$1,126,968,000 as against a total of $1,265,243,000 on July 9, 
1920, a decrease of only $138,257,000, which is more than 
accounted for by the decrease in the holdings of paper of this 
kind by the Federal Reserve Banks of Boston, New York, and 
Chicago. 

In other words, 

The bank liquidation which has taken place has been mainly 
in financial and industrial centers, and the figures do not indi- 
cate that there has during the past 12 months been any decrease 
in Federal Reserve accommodations to banks in the agricultural 
and live-stock districts, but on the contrary there has been a 
considerable increase. 

Similar figures chosen for other dates of 1920-21 point 
toward the same general conclusion. 

But such figures as these do not tell the whole story. As 
prices decline, the need for credit to accomplish the same 
volume of business recedes also. In the depression of busi- 
ness in 1920-21, the decline in agricultural prices pro- 
ceeded much faster than the reduction of credits. Since in 
the nine agricultural districts there was no decline in hold- 
ings of agricultural paper, it would appear as if in relation 
to the state of prices reserve funds were being enlarged 
considerably for the benefit of agriculture. The fall in the 
prices of wholesale agricultural products for this period is 
indicated by the following group index numbers supplied 
by the United States Bureau of Labor Statistics: ' 

^ Commodities have been regrouped by the Federal Reserve Board and the 
index numbers are published monthly in the Bulletin. 



150 FEDERAL RESERVE POLICY 





1913 = 


100 


1920 


1 


192 1 


June 


= 301 


January = 155 


July 


= 287 


February = 145 


August 


= 259 


March =136 


September 


= 232 


April = 126 


October 


= 191 


May =131 


November 


= 170 


June = 125 


December 


= 155 


July = 122 
August = 123 



These facts do not answer the question as to the treat- 
ment of the farming class accorded by the member banks 
themselves. But it should be remembered that the reserve 
manangement has no direct control over member banks' 
discount policy. So far as its operations are concerned, the 
reserve system appears to have displayed every desire to 
lessen the shock of the liquidation of 1920-21. 

It may be true also that the reserve management's 
general rediscount policy preceding the depression of 1920- 
21 is to be condemned. However this may be, it will later 
be shown that ample warnings were given for the rate 
increases of the fall of 1919 and for 1920; ' that these rate 
increases were made only when the reserves of the reserve 
banks were so low as to necessitate restrictive measures. 
Moreover, the reserve banks' discount rates tended to 
follow rather than to precede those of the general money 
market. The causes of the deflation were many; but fig- 
ures show that the responsibility of the reserve manage- 
ment, so far as the volume of discounts is concerned, was 
confined to checking the rate of credit expansion. There 
had to be a stop some time. 

In view of these many evidences of exceptional favors, 
to be found not merely in the statute, but also in the man- 
agement of the system, it is interesting to attempt to 

' See infra, Chapters XV and XVI. 



AGRICULTURAL CREDIT 151 

explain the general discontent with the reserve system 
manifested by the agricultural classes after the depression 
of 1920-21. That a genuine feeling of hostility has been 
created, in the farming districts of the Middle West and 
South particularly, cannot be doubted by anyone who has 
had the opportunity of coming into close personal contact 
with the farmers of these sections. The following explana- 
tions are offered: 

First of all, the farmer suffered relatively the most of all 
classes by the general price decline. Index figures for 
wholesale prices furnished by the United States Depart- 
ment of Labor's Bureau of Labor Statistics show that 
while farm products fell from a figure of 287 on July, 1920 
(1913-100), to 122 on July, 1 92 1, all commodities fell in 
the same period from 262 on July, 1920, to 148 on July, 
192 1. Retail prices fell even much more slowly. Of all 
classes the farmer was probably more convinced than any 
other that the price gains of the war period would be main- 
tained. Encouraged by his political representatives, by 
editors of agricultural journals, by officers of his organiza- 
tion, he was led to believe that the old order had changed 
once for all. Instead of creating rainy-day funds for future 
emergencies, his profits of war-time were employed to 
finance larger personal expenditures and the purchase of 
new land aiid more expensive equipment. In many local- 
ities of every agricultural State, land speculation forced 
prices up to a point where only the most careful husbandry 
could produce a fair return on the inflated values. The 
transportation breakdown and high freight rates contrib- 
uted to the decline in farm-products values. In all this 
the local banker was not without blame. It was his duty 
to prevent the use of bank funds for excessive speculation. 
In the localities where he failed most to assume this 
obligation, recovery from the depression was most difficult. 



152 FEDERAL RESERVE POLICY 

When pressed for credit he did not feel able to grant, the 
local banker frequently found it possible to throw respon- 
sibility upon the reserve management. The local banker 
pointed to the increased rediscount rates exacted by the 
district bank, and to warnings of the district directorate. 
The district bank could refer to the warnings and admoni- 
tions of the Federal Reserve Board. Political representa- 
tives in Congress, often without any real understanding 
of the nature of the reserve system, added to the pressure 
brought to bear against the Board. It was a grand old 
game of "passing the buck." In all this the emergency 
character of the reserve system was forgotten, as also the 
exceptional character of the war period. It was assumed 
that the reserve system was obligated to furnish funds for 
private profit-making purposes. To the writer it seems 
unfortunate that this turn of affairs was not anticipated 
earlier. The mistake of the reserve management (a mis- 
take, however. Treasury policy made it difficult to avoid) 
lay in permitting the expansion of the post-war period, not 
in checking it when it appeared about to pass all bounds of 
safety. 

There were also current many misconceptions as to the 
nature of the reserve system. As previously indicated, the 
regional character of the system often was overlooked. It 
was forgotten that the reserve bank in Kansas City is a 
different bank from that of New York. It serves a different 
set of industries and interests, and is managed by directors 
selected by a different group of men. The fact that credits 
are made available in one district for purposes denied in 
another does not necessarily indicate sectional partiality. 
It may mean solely that one reserve bank was previously 
more careful in its credit grants, and had built up a greater 
reserve to support new financing. 

It may have been unfortunate that in the financial 



AGRICULTURAL CREDIT 153 

centers security speculation could not have been subjected 
to more strict control. But our methods of war finance 
rendered this control difficult. We floated our bond issues 
at cheap rates by placing the resources of the reserve banks 
at the beck and call of member banks. Until the war-paper 
holdings of member banks were reduced it was difficult to 
render effective a policy of credit restraint. Finally the 
credit situation got out of hand. A check in the rate of 
increased grants of reserve funds was inevitable. Many 
mistakes were doubtless made in all this. But they were 
not mistakes of attempted and purposed discrimination 
against the agricultural borrowers. 

Finally, the farming class, as also others, has failed 
often to perceive the real character of the sort of opera- 
tions permitted for the reserve banks. The reserve system 
was intended to be an institution dealing, with a few ex- 
ceptions, in paper of a commercial character. Its reserves 
are the country's final and ultimate. They must be kept 
liquid. It never was contemplated that the reserve system 
should supply funds through the discount of paper arising 
in land or commodity speculation or for long-time develop- 
mental purposes. It may be legitimate for credits of this 
sort to be supplied by such institutions as^the War Finance 
Corporation or the Federal Farm Loan Banks. The writer 
would be one of the first to admit the necessity of develop- 
ing institutions for the sake of procuring for the farmer the 
funds of the saving and investing classes. But reserve 
funds are intended for other purposes. The reserve system 
is a set of regional banks designed to guarantee the liquid- 
ity of sound paper of commercial banks. 



CHAPTER VIII 
THE DEVELOPMENT OF THE BANK ACCEPTANCE 

Jn a previous chapter mention was made of the impor- 
tance generally ascribed to the work of popularizing the 
trade acceptance. Among the anticipated advantages was 
the devising of a type of paper which should command a 
broad and steady market and therefore comprise a suit- 
able investment for commercial banks. But in this respect 
the development of the bank acceptance deserves even 
greater mention. It would seem that no paper could be 
more liquid in open-market transactions than that ac- 
cepted by an institution with the financial status of a bank. 
The essential function of the bank acceptance is to sub- 
stitute for the inferior credit of the individual the more 
easily liquidated obligation of a bank. Because of the wide 
market for the bank acceptance, the bank may be able to 
meet the needs of its customer even though it itself is 
unable or non-desirous of making a straight loan. Instead 
of discounting its customer's note and furnishing the funds 
itself, the bank merely assists its customers to obtain the 
advance from some other institution. By accepting this 
draft the bank places the customer in possession of paper 
which may be sold to some other banking institution. The 
accepting bank assumes no responsibility until the date of 
the maturity of the draft. But on or before the date when 
payment becomes due, the customer is expected to pro- 
vide funds for the meeting of the draft. This may have 
been accomplished previously by the opening of a credit in 
favor of the individual, or by turning over to the bank for 



DEVELOPMENT OF BANK ACCEPTANCE 155 

collection customers* paper maturing at approximately the 
same date as the bank acceptance and aggregating perhaps 
a substantially equivalent amount. 

In the import trade past events had shown the necessity 
of the development of the acceptance method. When the 
seller of the goods resides in a foreign country, it is pecu- 
liarly desirable that the importer's bank be permitted to 
accept the draft. The standing of the importer may not be 
sufficient to enable him, by means of his own acceptance, 
to add much strength to the bill drawn by the foreign ex- 
porter. Prior to 19 13 acceptance powers were not con- 
ferred by law upon national banks. Accordingly, when 
occasions arose which necessitated the substitution of a 
bank for the American importer as acceptor, reliance 
might have to be placed upon some foreign banking insti- 
tution. This could be accomplished by the American 
bank's issuance to its customer of a letter of credit ad- 
dressed to some London institution requesting that it 
accept the bill. Arrangements would be made whereby the 
London institution would be supplied with funds to meet, 
on maturity, any draft drawn under the letter of credit. 

In several ways this financing through London was not 
thoroughly satisfactory to American trade and banking 
interests. In the first place, this method virtually required 
the American firm to pay two commissions, the one repre- 
senting compensation for the service of the AmericaiC 
institution in issuing the letter of credit, the other compen- 
sation for the London bank in honoring it. The entire 
service could have been rendered by the American institu- 
tion had legal authority for the acceptance existed. In the 
aggregate the yearly charges upon American industry 
which went to swell the revenues of London institutions 
were very great. London was securing business which 
might have been performed by our own banks. 



156 FEDERAL RESERVE POLICY 

Reliance upon London increased the difficulty, more- 
over, of developing the use of the dollar exchange in inter- 
national transactions. Drafts drawn against English 
houses must necessarily be couched most frequently in 
terms of sterling. When the time arrived for furnishing 
* 'cover," the American firm would be obliged to provide 
whatever sum in dollars the prevailing quotations on 
sterling would make necessary. The risks of exchange 
fluctuations were borne by American trading interests. 

In the endeavor to avoid this loss by exchange, the 
American firm might make forward contracts for the 
amount of sterling credits necessary for cover. But this 
only meant that the risk in exchange was placed on 
the shoulders of another party. The assumption of this risk 
was a service demanding compensation. Payment for it 
represented an increase burden upon American trade. 

In the financing of the export trade a similar necessity 
existed for the bank acceptance. Let us suppose that an 
exporter in New York ships goods to a buyer in Buenos 
Aires. Immediately he draws a draft upon the buyer and 
attaches thereto the shipping documents covering the 
goods sold. In case the shipper's bank is in position to dis- 
count the draft, no difficulty would arise in the financing 
of the transaction. The seller secures his funds at once, 
and is liable only in case of the inability of the bank to 
collect from the purchaser in Buenos Aires. 

In many situations, however, the ability of the bank to 
discount these bills would be limited. The bills ran cus- 
tomarily for a long period of time. Relatively speaking, 
South American countries have been capital-poor coun- 
tries. They must buy largely on time. Their industries, 
moreover, are dependent largely upon agriculture. In 
years of poor crops or of a depressed foreign market abroad 
for their agricultural produce, the period of liquidation is 



DEVELOPMENT OF BANK ACCEPTANCE 157 

prolonged. Frequent renewals become necessary. Under 
these conditions the American bank might feel obliged to 
refuse a straight discount. 

By means of the acceptance, however, the bank may be 
able to aid the seller to secure the funds immediately in the 
open market. The exporter draws another draft against 
his bank, which accepts it under condition that the trade 
draft will be turned over to it for collection, the proceeds 
to be employed to cancel the acceptance credit. The bank, 
either directly or through some other American house, 
forwards the trade draft with the shipping document to a 
Buenos Aires correspondent. When the buyer accepts the 
draft he receives the shipping documents. By this method 
the American seller is given negotiable paper, which can 
be discounted in the general market because of the strength 
given by the bank's acceptance. 

Not only was it argued that bank acceptance would 
enable the exporter to secure his funds quickly, but it was 
also anticipated that it would offer a means whereby the 
financing of foreign trade could be deflected from New 
York to London as money market conditions might neces- 
sitate. Regarding this point we read in the Bulletin for 
May I, 1915:^ 

The importance of the development of this banking instru- 
ment Is now beginning to be generally understood, and inquiries 
which have been made indicate that additional banks are pre- 
paring to offer accepting facilities to their customers. From 
the point of view of the development of a stable market in New' 
York City for dollar acceptances, this Is of Importance, for such 
a market depends primarily upon a large, steady volume and 
low, steady rates. Several banks and firms dealing In bills have 
also, largely within the present month, begun to quote forward 
rates on bills drawn in dollars, so that exporters In distant 
countries may be able to calculate the comparative negotiable 

' Page 53. 



158 FEDERAL RESERVE POLICY 

value of sterling and dollar drafts. This is also of fundamental 
importance in the development of the acceptance business. 
When the movement of our exports and imports has been suffi- 
ciently standardized through bankers' acceptances, so that it 
may be facilitated as easily in the New York as in the London 
market, even though the volume in the New York market may 
be much smaller, we should be enabled readily in the future, 
when we wish to protect our reserves or when they are needed 
for domestic expansion or seasonal movements of commodities, 
to deflect the financing of our foreign trade from New York to 
London by raising New York rates above London rates and 
making it cheaper for the shipper to draw on London than on 
New York. Conversely, when we are ready to finance it again 
we should be able, in normal times, to recover the business from 
London by reducing our rates below those of London. At other 
times, of course, London may take the initiative in readjusting 
the rates for one or another of these purposes, just as its rates 
have been raised substantially during the past 30 days as a 
protection to its reserves. 

In general the bank acceptance was regarded as necessary 
in order that our financial centers might assume, in the 
field of international finance, the place commensurate with 
the importance of American trade and industry. 

Most of the above considerations were stressed also in 
discussions relating to the financing of domestic trade. 
Aside from the fact that foreign trade involves the trans- 
lation of the medium of exchange of one country into that 
of another, distant domestic transactions offer the same 
problems as foreign. It is still necessary to find a means of 
substituting bank time-credit for the credit of the indi- 
vidual. But the points emphasized most largely in the days 
of banking-reform discussion were the aid which the ac- 
ceptance might render; first, in the campaign to create a 
broad and steady market for commercial paper ; and second, 
in the equalization in some degree of money rates in dif- 
ferent sections of the country. 



DEVELOPMENT OF BANK ACCEPTANCE 159 

In regard to the first matter it was argued that the bank 
acceptance would do much to standardize the commercial 
paper available for bank investments. The credit of 
individuals varies in quality, but paper representing the 
obligations of banks should possess some degree of uni- 
formity. The bank acceptance offered a means of substi- 
tuting the one type of paper for the other. If commercial 
paper could be thus standardized, much would be accom- 
plished in the way of relieving the stock market from the 
uncertainties of the call-loan market. As an element in 
banks* secondary reserves it was anticipated that the 
acceptance might become the most important item. It was 
argued that this would constitute an advantage for the 
security investment as well as for the banking interests. 
Stocks and bonds of fluctuating value should be financed 
by time loans. In no other way can they be relieved on 
intimate dependence upon momentary changes in money 
rates. 

As a second advantage, it was urged that the acceptance 
would assist in the transfer of banking funds from the capi- 
tal-poor to the capital-rich sections of the country. Pre- 
viously, such a redistribution in the employment of bank 
funds was made diflftcult because of the inferiority of pri- 
vate credit in the borrowing sections. The acceptance 
offered a means of overcoming this difficulty to some extent 
in short-time transactions. Eastern banks would be 
expected to show more willingness to purchase paper 
accepted by a Western bank than that of a private 
individual. 

Under the terms of the banking laws of some States 
recognition of the merit of the acceptance had been made 
prior to the passage of the Federal Reserve Act. In the 
Report of the Board for the year 1919 we read:* 

» Page 21. 



i6o FEDERAL RESERVE POLICY 

Incorporated banks were first permitted to accept about lo 
years ago under the laws of some of the States in which they 
were domiciled. 

It is by the terms of the act, however, that national banks 
are first endowed with acceptance powers. According to 
the terms of the original statute member banks were given 
the right to^ 

accept drafts or bills of exchange drawn upon it and growing 
out of transactions involving the importation or exportation 
of goods having not more than six months' sight to run. 

In view of the arguments previously advanced in behalf 
of the use of the acceptance in domestic trade, it may seem 
strange to note that the original act confined its use to 
foreign-commerce transactions. Explanation for this fact, 
however, is not difficult to find. In the first place, it -was not 
desired that in the beginning the bank-acceptance method 
should be pushed among all sorts of institutions. It was 
hoped that its use might be confined to banks of the high- 
est degree of solvency. As a rule institutions which had 
been prominent in foreign-trade financing were classified 
among those of highest solvency. 

In the second place, it was perceived that the foreign 
trade acceptance was necessary in order to encourage the 
use of the dollar exchange. As long as London banks 
accepted for international trade purposes, the banker's 
bill, in the great majority of cases, would be drawn in 
terms of sterling money. This was a matter which involved 
rivalry with a foreign banking mart; it seemed especially 
important that restrictions preventing our banking institu- 
tions from competing on even terms with the foreign should 
be removed. 

Finally, the inflationary possibilities of the bank ac- 

* Section 13. 



DEVELOPMENT OF BANK ACCEPTANCE i6i 

ceptance were recognized. As indicated previously the 
acceptance method offers a means whereby local indus- 
tries may be permitted to draw upon surplus funds in the 
outside banking community. There was danger that credits 
should be offered too liberally; credits not merely in the 
aggregate, but also in the amount extended to a single firm. 
Accordingly, the original act confined its use to one single 
type of transactions. 

Subsequently,'^ however, the act was amended to permit 
of its employment in other types of transactions. These 
were : first, for the purpose of creating dollar exchange; 
secondly, to finance the domestic shipments of goods; 
thirdly, to permit the temporary storage of staples pend- 
ing a reasonably prompt sale or distribution. 

The reader of section 13 may be somewhat confused by 
the very many restrictions confining the use of the bank 
acceptance. Some of these restrictions were a part of the 
original act; others were introduced in subsequent amend- 
ments. It may be desirable, therefore, to inquire as to the 
motives of the lawmakers in inserting these restrictions in 
the statute. Aside from matters previously mentioned — 
the desire to preserve for the acceptance a distinctive 
place as a superior type of commercial paper available for 
member banks' secondary reserves, and the fear of its 
inflationary possibilities — the following explanations 
may be ventured. First, it was made available for redis- 
count or purchase by reserve banks at a specially low rate. 
For a considerable period after the acceptance regulations 
were issued by the Board, the rates on such rediscounts 
were announced as varying between two and four per cent. 
The minimum figure was considerably less than the average 
rate on other paper. A consideration determining whether 
the rate would correspond more closely with the maximum 

* By the amending act of September 7, 1916. 



i62 FEDERAL RESERVE POLICY 

or minimum would be the standing of the firm acting as 
acceptor. A higher rate would be a means of discouraging 
the offer of undesired acceptances. As stated by the Board 
in an Informal Ruling in the November i, 1915, Bulletin: ^ 

It is, of course, understood that the Board would not wish to 
see concerns regarded as eligible acceptors which are not in 
the habit of carrying on some acceptance business regularly 
and are not generally of such character and standing as to qual- 
ify their acceptance as a banker's acceptance. 

As in the case of the trade acceptance, it was to be expected 
that many illegitimate attempts would be made to gain the 
advantage of the low rates. 

As a second explanation, it was to be expected that the 
bank acceptance as a superior type of commercial paper 
would come to occupy a prominent place in the portfolios 
of reserve banks. In the early days of operation the sup- 
port of the reserve banks would be necessary in order to 
encourage its use. Later, large amounts of acceptances 
would be purchased by reserve banks as a part of their 
open-market operations. It was emphatically necessary 
that the reserve banks keep their assets in liquid shape. 
Precautions were felt to be peculiarly necessary in order to 
prevent an unduly rapid growth of such paper. 

Finally, with certain exceptions, the limitations of sec- 
tion 5200 would not apply to the bank acceptance. The 
theory justifying this exception is that an acceptance is not 
a loan of money. The accepting bank merely lends its 
credit to the maker of the bill. The bank's responsibility 
is contingent only and not direct. Because of the remote- 
ness of loss under this contingent guarantee, it was not 
esteemed necessary to provide for the application of the 
same laws which govern the straight loan. Accordingly, 

» Page 36. 



DEVELOPMENT OF BANK ACCEPTANCE 163 

by the amendment of September 7, 19 16, a sentence in 
section 13 was made to read: 

No member bank shall accept, whether in a foreign or domes- 
tic transaction, for any one person, company, firm, or corpora- 
tion to an amount equal at any time in the aggregate to more 
than ten per centum of its paid-up and unimpaired capital stock 
and surplus, unless the bank is secured either by attached 
documents or by some other actual security growing out of the 
same transaction as the acceptance. 

This was a negative way of providing that acceptances 
thus secured might be made to an amount exceeding ten 
per cent of the capital and surplus. But if not secured, the 
liability of the bank, contingent though it be, was con- 
sidered too great. If law established for the acceptance 
no such limitation as section 5200 provided for the straight 
loan, all the greater appeared the necessity of imposing 
other restrictions. 

While discussing this matter intrepretation should be 
made of the phrase, *' attached documents or by some 
other actual security.'* It is evident that the documents 
must be surrendered to the purchaser before the latter 
can obtain the goods, and that after their surrender the 
documents are not in the possession of the bank. To cover 
this situation the following ruling was announced by the 
Board in the February, 191 9, Bulletin: ^ 

It [a member bank] cannot accept in domestic transactions 
without being secured at the time of acceptance, but may re- 
lease the security after acceptance upon the execution of a trust 
receipt or an agreement by the customer that so much of the 
proceeds of the sale of the goods covered by the security as may 
be necessary to pay the draft will be deposited with the accept- 
ing bank when available and will not be used for other purposes. 

Under certain conditions, however, an acceptance would 

» Page 143. 



164 FEDERAL RESERVE POLICY 

become for all practical purposes a loan or a discount. 
Under such conditions section 5200 would apply. One of 
these situations would be that in which the accepting bank 
some time subsequent to acceptance purchases its own 
acceptance. 

This practice, the purchase by the bank of its own 
acceptance, was not welcomed as customary procedure. An 
acceptance is a means whereby some other bank is to fur- 
nish the funds. On certain occasions, however, such action 
might prove necessary. If no outside demand for the 
acceptance occurred, the only means of protecting the 
acceptance market would be for the accepting bank to make 
the purchase. Such action might be defended on the 
ground that the acceptance method must not be permitted 
to fall into disrepute. 

Ordinarily, however, such action should not prove nec- 
essary. So desirous have the reserve authorities been that 
the bank-acceptance method should be encouraged for 
legitimate purposes, and so well fortified have the reserve 
banks been in their open-market powers, that the market 
should not customarily fail for prime acceptance paper. 
Although somewhat handicapped by the slow develop- 
ment of special discount corporations, the acceptance 
demand has been enlarged recently on the part of other 
institutions, as, for instance, savings banks. In some 
cases, furthermore, it appeared that the purchase of the 
bank's own acceptance was an attempt to evade the limi- 
tations of section 5200 and find a means of advancing more 
to one party than an amount corresponding to ten per 
cent of the bank's capital and surplus. - 

By an Informal Ruling, however, announcement was 
made that such practices could not be permitted to accom- 
plish their purposes.^ It was insisted that acceptances 

» Bulletin^ January i, 1917, p. 28. 



DEVELOPMENT OF BANK ACCEPTANCE 165 

purchased by the accepting bank must be considered as 
loans. In such cases the bank's obligation is direct, and 
not merely contingent. 

The acceptance method, furthermore, contemplated 
that the acceptance credit would be eliminated by remit- 
tance of ''cover" to the bank on or before the maturity of 
the acceptance. If the indebtedness of the drawer is not 
destroyed, the bank assumes the position of making a 
direct advance. Exception to this statement might be 
made only in case the payee permitted the renewal of the 
acceptance. It is not surprising, therefore, to find in the 
Bulletin for February, 191 6,' an Informal Ruling to the 
effect that 

the provisions of section 5200 of the United States Revised 
Statutes would apply to the indebtedness arising between the 
drawer of the bill and the accepting bank in case the drawer 
fails to furnish funds with which to meet the acceptance. 

A somewhat confusing situation might arise, however, 
in the case of the rediscount of an acceptance which had 
been purchased previously by the accepting bank. By the 
act of rediscount, which transfers the paper to another 
institution, the bank ceases to occupy the position of a 
lerdar of money. After rediscount its liability is precisely 
the same as that which existed before the purchase of the 
bill. The bank's obligation becomes contingent only. Sec- 
tion 5200 does not apply."* 

We may next consider the conditions governing the use 
of the acceptance for various classes of permitted pur- 
poses. Let us first turn our attention to the use of the 
acceptance in the establishment of the dollar exchange. 
By the amendment of September 7, 1916, member banks 

» Page 64. 

* Cf. Opinion of Counsel, Bulletin, September i, 1917, p. 696. 



i66 FEDERAL RESERVE POLICY 

were empowered, with the special permission of the Fed- 
eral Reserve Board, to accept drafts 

for the purpose of furnishing dollar exchange as required by the 
usages of trade in the respective countries, dependencies, or 
insular possessions. 

The Federal Reserve Board was given power to determine 
whether the country's trade usages were such as to necessi- 
tate the acceptance of drafts originating therein. In the 
December i, 191 6, Bulletin,^ we are informed that appli- 
cations had been granted for the acceptance of drafts 
drawn in Porto Rico, Santo Domingo, Costa Rica, Peru, 
Chile, Brazil, Venezuela, Argentina and Bolivia. The 
Board refused "^ to include England or France in this list. 
The reason for this discrimination was explained as follows : ^ 

The purpose of this Act and the regulation made pursuant 
thereto was to enable the American banks to provide dollar 
exchange in countries where the check is not the current means 
of remittance in payment of foreign debts, but where the three 
months' bankers' draft is generally used for that purpose. . . . 

The Board is informed that the bankers' custom of selling 
three months' drafts in preference to checks originated in coun- 
tries where the mail connections were irregular and the foreign- 
exchange market was a limited one, and where it would have 
been difficult for the drawing banker to be certain that he could 
find a cover against the checks drawn by him in time to forward 
it by the same mail, whereas, in drawing a three months' draft, 
he would feel assured of being able to forward remittances 
before his obligation fell due. 

In other words, irregular mail connections make it 
impossible frequently to depend upon the immediate 
remittance of ''cover. " In such cases, a time bill is desired, 
giving sufficient opportunity for remittance. 

» Page 665. 

a Ihid., p. 666. 

5 Ihid., pp. 665, 666, 



DEVELOPMENT OF BANK ACCEPTANCE 167 

In a ruling by the Board ^ it appears that attempts have 
been made to draw such bills when the usages of trade 
were not such as to require them. In some countries where 
the dollar was at a premium such drafts would be drawn 
to supply the needed exchange. The Board ruled that 
these drafts could not be accepted by American banks. It 
appears, therefore, that **the usages of trade" refers solely 
to the customs created because of the lack of regular mail 
connections. 

Statutory limitations upon the ability of banks to accept 
such drafts were as follows : In no case could the amount 
of acceptances exceed one half the capital and surplus of 
the accepting bank. Ten per cent of the capital and sur- 
plus would be the maximum unless "the draft or bill of 
exchange is accompanied by documents conveying or 
securing title or by some other adequate security. ** 

The second class of bankers' acceptances were those 
arising out of the importation or exportation of goods. In 
absence of special permission from the Board, member 
banks are given the right to accept to an amount equal to 
fifty per cent of their capital and surplus. The Board is 
empowered, however, to grant permission to applying banks 
to accept up to one hundred per cent of the capital and 
surplus. In pursuance of this power the Board has regu- 
larly published the names of banks which are to be per- 
mitted to accept the larger amount. 

The reason for the insertion of such restrictions in the 
statute is not difficult to explain. The acceptance is a 
means whereby the accepting bank aids its customer to 
secure funds from the outside banking community. 
Clearly no one bank should be permitted to draw too heav- 
ily upon other banks for the benefit of its own customers. 
Stating the limitation in terms of a maximum and a mini- 

' Bulletin, August, 1920, p. 835. 



168 FEDERAL RESERVE POLICY 

mum gives the Board some discretion regarding the sort 
of banks which are to be granted in greatest degree the 
acceptance privilege. In order to ensure the acseptance 
against misuse, the Board has been unwilhng to encourage 
its employment on the part of firms whose standing is not 
of the highest. 

During the foreign-trade boom following the armistice, 
assertions were made frequently that these limitations 
were too severe. It may well be that, in the course of time, 
a further amendment to the statute will be necessary. But 
in this period the volume of foreign trade was extraor- 
dinarily great. Under more normal conditions the need of 
the acceptance should not prove so great. It may be 
preferable, furthermore, to extend its use among a larger 
number of banks before granting greater powers to any one. 

As in the case of the domestic acceptance, member 
banks may accept drafts which arise in foreign trade hav- 
ing a maturity of six months. The maturity of a draft, 
rediscounted by a reserve bank, however, must not exceed 
three months. It cannot be granted under an agreement 
to renew.' The purpose of the acceptance was merely to 
finance transactions capable of being liquidated in a com- 
paratively brief period. Funds, desired for longer pur- 
poses, should be obtained by means of a straight loan. 
Since a direct loan would be subject to the restrictions of 
section 5200, Revised Statutes, agreement to renew an 
acceptance would offer virtually a means of evading the 
terms of the statute. 

This should not be interpreted, however, as denying a 
member bank the privilege of granting an acceptance 
credit outrunning six months. The acceptance credit may 
be considered merely as permission to draw the drafts. The 
limitation applies to the maturity of the drafts, not to the 

* Cf. Opinion of Counsel, Bulletin, March, 1920, pp. 7yy-y%, 



DEVELOPMENT OF BANK ACCEPTANCE 169 

length of the period during which such drafts may be 
drawn. 

A problem of some difficulty had to do with the means 
of identifying a foreign-trade transaction. How could it be 
distinguished from an operation of domestic trade? In 
case the dealer handled only goods in foreign trade, the 
presumption would be clearly in favor of classifying it as 
a foreign-trade acceptance. But if the party handled goods 
for the domestic as well as for the foreign trade, it would 
be more difficult to determine to which class it belonged. 
In the latter case, accordingly, it has been ruled that the 
dealer could be required to display a contract for foreign 
sale. It would not be necessary, however, to identify in 
the export trade the specific goods placed on board ship.^ 

In the early days of reserve operation it was easy to 
understand the necessity of distinguishing between foreign 
and domestic-trade acceptances. Then, acceptances could 
be given only to finance transactions arising out of the 
importation or exportation of goods. But later amend- 
ments permitted domestic acceptances under conditions 
substantially similar to foreign. In what, then, consists 
the value of this distinction to-day? The answer consists 
in part of the provision that whereas member banks may 
be permitted to accept both classes of bills up to an amount 
equal to one hundred per cent of their capital and surplus, 
"acceptances growing out of domestic transactions shall 
in no event exceed fifty per cent of such capital stock and 
surplus." To determine whether any one bank is exceed- 
ing its acceptance powers, it is necessary to learn how 
large are its acceptances for domestic and how large for 
foreign-trade financing. 

The provisions of the original act relating to foreign- 
trade transactions were drawn in rather general terms. It 

» Cf. Informal Ruling, Bulletin, December i, 1915, pp. 405-06. 



170 FEDERAL RESERVE POLICY 

was merely stated that the transaction must involve the 
importation or exportation of goods. Would it be suffi- 
cient, then, if the ultimate object of the transaction was to 
supply goods for export? 

The Opinion of Counsel in this matter is stated in the 
Bulletin for September i, 1915.^ To quote the terms of the 
inquiry stated therein : 

A domestic corporation, which for convenience will be desig- 
nated ''Company A," enters into a contract with another 
domestic corporation, designated "Company B," to furnish 
material to be used by Company B in the manufacture of 
products which Company B is under contract with a foreign 
purchaser to export. Query: Can a national bank accept a 
draft or bill of exchange drawn by Company A and accompanied 
by the necessary documents? 

It is obvious that to hold such an operation ^'foreign 
trade" would be to widen enormously the permitted 
classes of acceptance transactions. Many domestic trans- 
actions result finally in a foreign sale. Many of them fre- 
quently would be difficult to trace. It is not surprising, 
therefore, that Counsel ruled that the transaction itself 
must involve a foreign sale or purchase. It is not enough 
that the domestic transaction be merely related to the 
foreign. 

Let us now turn out attention to domestic acceptances. 
The first class of these acceptances permitted by the 
statute are those growing out of domestic shipments of 
goods secured by the attachment of shipping documents 
conveying title to the goods . In this respect such domes- 
tic acceptances stand on a different basis from the foreign- 
trade acceptance. In the case of the latter the provisions 
of the statute were intended merely to ensure the fact that 
there had been a shipment. Congress evidently intended, 
» Page 276c 



DEVELOPMENT OF BANK ACCEPTANCE 171 

however, to restrict domestic acceptances to a greater 
extent, because it provided that the shipping documents 
must convey to the accepting bank title to the goods. Such 
goods can be released to the purchaser, however, on the 
execution of a deed of trust stipulating that the proceeds 
from the sale shall first be devoted to the cancellation of 
the acceptance credit.^ The release of the security would 
cause, however, the limitations of section 5200 to apply. 
In that case the bank is secured neither by the attached 
documents nor by the actual security of the goods.^ 

The!more strict limitations upon domestic acceptances 
were due to the possibilities of greater abuses. The volume 
of domestic transactions is much greater than that of for- 
eign. Greater possibilities of evil attach, therefore, to the 
domestic acceptance. 

The duration of these acceptances may be as great as 
six months. But in no case may they run for a period 
longer than necessary to finance the sale.^ 

An interesting question arises as to the power to accept 
when a corporation is making a shipment of goods to its 
own agent. Such a transfer could not be considered as a 
sale. It would not seem legitimate to permit a draft to be 
accepted for any other purpose than to finance the ship- 
ment, to offset temporarily the cost of transporting the 
goods. In this case the maturity of the draft should 
approximate the duration of their transit.'' 

The principal concern of the Board has thus been to con- 
fine the use of this type of the bank acceptance to the 
financing of the shipment or the sale of the goods. Funds 
desired to enable the goods to be carried through the 
process of manufacture into finished products should not 

» Cf. supra, pp. 1 80-18 1. 

" Cf. Informal Ruling, Bulletin, March, 192 1, p. 308. 

3 Ibid., p. 308. 

4Cf. Informal Ruling, Bulletin, September i, 19 17, p. 690. 



172 FEDERAL RESERVE POLICY 

be financed by the acceptance. The acceptance should not 
be employed to secure working capital. Funds for such 
uses should be obtained by the discount of the borrower's 
promissory note. The acceptance contemplates the ex- 
tinction of the credit from the proceeds of the goods 
obtained by the sale of the acceptance. 

The second class of permitted domestic acceptances 
was those secured at the time of the acceptance by ware- 
house receipts conveying title to readily marketable 
goods. The function of this acceptance is to assist the 
producer in the orderly marketing of farm crops. If funds 
could not be obtained freely to hold the products of the 
farm in the locality of their production for a reasonably 
quick sale, the producer would be more largely dependent 
upon the offer of outside capital. The producer can well 
argue that means should be found to place him on the 
same basis as the outside purchaser with reference to his 
ability to obtain banking capital. Banking capital may be 
scarce in the growing section. Since the security must 
be that of "readily marketable staples" only, the risk of 
the bank which grants the acceptance credit should not 
be great ordinarily. 

Such methods as these could be abused easily if no 
limit were placed on the period for which the funds thus 
obtained could be employed. By a permanent advance of 
funds the bank might be supplying capital for commodity 
speculation. Legitimate use of the acceptance for this pur- 
pose was thus stated by Counsel of the Board as follows: 
The purpose must be 

to carry goods covered by warehouse receipt pending a reason- 
ably immediate shipment, a reasonably immediate sale, or a 
reasonably immediate distribution into the process of 
manufacture.^ 

« Cf . Opinion of Counsel, Bulletin, January i, 1920, p. 67. 



DEVELOPMENT OF BANK ACCEPTANCE 173 

The acceptance must not be made subject to renewals.* 
The security may be cattle provided the maturity is no 
longer than that required to fatten and resell.* 

The use made of this type of the acceptance must depend 
upon the definition of ''readily marketable staples." *In 
the Bulletin for July, 1919,^ the Board stated: 

A readily marketable staple may be defined as an article of 
commerce, agriculture, or industry of such uses as to make it 
the subject of constant dealings in ready markets with such 
frequent quotations of prices as to make (a) the price "easily 
and definitely ascertainable and (b) the staple itself easy to 
realize upon by sale at any time. 

This definition would bar the use of the acceptance for the 
great majority of manufactured articles. Acceptances 
secured by warehouse receipts to automobiles and auto- 
mobile tires were held by the Board in the January, 1920, 
Bulletin ^ to be unwarranted. This class of acceptances 
may be considered, therefore, as devised in largest 
measure to meet the special marketing needs of the 
agricultural borrower. 

The restrictions thus far mentioned relate to the power 
of member banks to accept. It is necessary next to learn 
the conditions governing the power of reserve banks to 
acquire acceptances. 

Under its discount powers, reserve banks can acquire 
acceptances maturing within three months from date of 
discount. Six-months acceptances must be held, there- 
fore, for a period of three months before they become 
eligible for discount with a reserve bank. Until May, 
192 1, the acceptance was treated as a commercial bill, and 

' Bulletin, March, 1920, p. 277. 

» Cf. Informal Ruling, Bulletin, July, 1921, p. 315. 

5 Page 652. 

4 Page 65. 



174 FEDERAL RESERVE POLICY 

subject, therefore, to the statutory limitations applicable 
to such paper. But in that month foreign trade conditions 
were interpreted to be such as to warrant an extension of 
maturities. Accordingly, in the desire to encourage the 
granting of acceptances of longer maturity by member 
banks, an exception was made by a ruling of the Board 
whereby acceptances growing out of transactions involving 
the importation or exportation of goods might be eligible 
for purchase by reserve banks even though the maturity 
at the time of purchase was as great as six months.' 
A further reason for this regulation was to widen the 
acceptance market by adapting acceptances to the re- 
quirements of savings banks. Foreign-trade acceptances 
might be desired by these institutions if the reserve 
banks had power to protect the market by acquiring 
acceptances of longer maturities. By extending the 
maturities of bills eligible for purchase the protecting 
power of reserve banks would be enlarged.^ 

Bankers' acceptances rediscounted under the terms of 
section 13 must be endorsed by a member bank. Open- 
market purchases under section 14 need not be endorsed. 
Nevertheless, the policy of the Board has been to take all 
feasible steps to ensure the worth of paper thus acquired. 
Accordingly, by Section B, Series of 192 1, it was held that 
an unendorsed acceptance *'is not eligible for purchase 
until the acceptor has furnished a satisfactory statement 
of its financial condition,*' and agrees to submit any 
information concerning the underlying transaction re- 
quested by the Federal Reserve bank. 

An endorsement by the accepting bank adds little, how- 
ever, to the strength of the acceptance. Accordingly, the 
Board has not welcomed purchases directly from the 

' See infra., pp. 191- 192. 

»Cf. BvUetin, June i, 1921, p. 648. 



DEVELOPMENT OF BANK ACCEPTANCE 175 

accepting bank. It prefers that the acceptance should be 
acquired from another bank. It was only because of the 
weak market for acceptances in some districts that pur- 
chase directly from the accepting institution has been 
condoned. But in February, 1920, reserve banks were 
instructed to make all such purchases at the rate appli- 
cable to commercial paper rather than at the preferential 
rate applicable to bankers' acceptances.' 

Open market purchases under section 14 are not subject 
to the requirements of section 13, that the paper acquired 
by reserve banks shall not bear the name of a borrower 
indebted to the member bank to an amount exceeding ten 
per cent of the bank's capital and surplus. Nevertheless, 
as a matter of banking policy the Board announced that it 
desired member banks to recognize this restriction as ap- 
plicable to open-market purchases. Discretion in this 
matter, however, is left to the district banks. 

The preceding discussion relates exclusively to the 
acceptance powers of member and reserve banks. By a 
series of amendments to section 25 of the act, member 
banks have been endowed gradually with powers to invest 
in the stock of corporations possessing certain acceptance 
privileges. Let us turn our attention next to this matter of 
syndicate acceptance development. 

Section 25 of the original act gave national banking 
associations, with a capital and surplus of more than 
? 1, 000,000, power to establish branches in foreign coun- 
tries for the "furtherance of the foreign commerce of the 
United States, and to act, if required to do so, as fiscal 
agents of the United States. " In the discussion preceding 
the passage of the act on December 23, 19 13, the public 
had been rather thoroughly educated regarding the 
necessity of such foreign branches. In the matter of for- 

* Cf. Bulletin, June, 192 1, p. 699. 



176 FEDER.\L RESERVE POLICY 

eign trade some foreign agency must act as the foreign 
correspondent of the American bank in such matters as 
the making of collections on export bills, honoring and 
issuing letters of credit, supplying credit information for 
the benefit of American industry. Foreign banks, under 
the control of, and devoted primarily to the welfare of, 
foreign industry could not be expected to perform all. 
these services with strict secrecy and impartiality. It was 
a matter of frequent comment that American trade 
secrets found frequent disclosure through the medium of 
foreign banks. It is not strange, therefore, that our legis- 
lators decided to equip certain types of our banks with 
powers more in accordance with those possessed by their 
foreign banking competitors. 

Under the terms of this section many foreign branches 
were established. It soon appeared, however, that the act 
did not go quite far enough. Banks which were not 
desirous themselves of establishing these foreign branches 
insisted that they should be permitted to cooperate with 
other banks in the organization of foreign banking institu- 
tions. Accordingly, the amendment of September 7, 19 16, 
contained a provision permitting certain types of banks to 
subscribe to stock in institutions ** chartered or incorpo- 
rated under the laws of the United States or of any State 
thereof, and principally engaged in international or for- 
eign banking." 

The work of institutions of this sort must be largely of a 
commercial nature. Their advances must be, in large meas- 
ure, short-time advances. In the period following the 
signing of the armistice, however, it became clear that the 
industrial needs of Europe were such as to demand the 
granting of credits running for a relatively long period of 
time. By a further amendment to section 25, signed by 
the President on September 17, 19 19, national banks were 



DEVELOPMENT OF BANK ACCEPTANCE 177 

empowered to assist in the formation of institutions to 
provide investment as well as commercial credit. Corpo- 
rations to be formed under the authority of this legislation 
must be "principally engaged in such phases of inter- 
national or foreign financial operations as may be neces- 
sary to facilitate the export of goods. " 

But while stock might be subscribed in such institu- 
tions, no means were provided for the Federal incorpora- 
tion of foreign banking corporations. By further amend- 
ment to section 25, which became law on December 24, 
1919, the so-called Edge Act, this difficulty was eliminated. 

At the time of the passage of the Edge Act its purpose 
was generally proclaimed to be the assisting of Europe in 
the reconstruction programme. In the April, 1920, Bulle- 
tin,^ however, we are informed that it should not be re- 
garded as merely of temporary importance. Its permanent 
endeavor was to provide for the establishment of federally 
incorporated institutions with sufficient power to compete 
on even terms with foreign institutions. In Europe insti- 
tutions of the type of the "investment trust" had long 
since been developed to encourage foreign trade and for- 
eign investment. The basic purpose of these institutions 
is to substitute for the investor domestic for foreign securi- 
ties. To obtain capital from its investing public its own 
debentures are offered. These debentures should be safer 
than those possible of individual selection. The invest- 
ments of the company are much more widely diversified 
than an individual's of limited means possibly can be. 
They are superintended by an official with special oppor- 
tunities to investigate the worth of foreign securities pur- 
chased. The investment trust, furthermore, can conduct 
its operations on a scale impossible for that of the indi- 
vidual. Its capital is collected from a number of savers. 

* Pages 379-82. 



178 FEDERAL RESERVE POLICY 

Finally, the purchaser of the debentures could be fortified 
by the knowledge that shrinkage of earnings would be 
borne first by the company's shareholders, and that not 
until the losses wipe out the capital and surplus is his own 
equity disturbed. Corporations organized in this coun- 
try under the Edge Act would possess power to purchase 
securities in companies conducting a business engaged in 
foreign trade. 

Corporations formed under this act may operate either 
on a debenture or on an acceptance basis. In view of the 
fact that the framers of the legislation undoubtedly had in 
mind an institution of the type of the foreign ''investment 
trust, " it may seem difficult to account for its acceptance 
powers. It might appear that the issuance of debentures 
alone would suffice. It must be remembered, however, 
that the purpose of these corporations was to supply for 
foreign-trade purposes short- as well as long-term credit. In 
the matter of short-term acceptance credits, member 
banks felt the limitations on the aggregate permitted by 
section 13 rather severe. The Edge Act offers a means of 
lessening this difficulty. 

Under the terms of the law the acceptance of bills and 
drafts was to be subject to any limitations and restric- 
tions the Federal Reserve Board might impose. By Regu- 
lation K, Series of 1920, the Board has permitted corpora- 
tions which issue no debentures to make acceptances for 
the purpose of supplying dollar exchange and for the pur- 
pose of furthering the importation or exportation of goods 
Bills accepted of the first class may run for three months t 
those for the last class six months. For one drawer accept- 
ances cannot exceed ten per cent of the capital and surplus 
"unless the transaction be secured or represents an expor- 
tation or importation of commodities and is guaranteed by 
a bank or banker of undoubted solvency." Limitations 



DEVELOPMENT OF BANK ACCEPTANCE 179 

upon the aggregate volume of acceptances were to be 
governed by the following regulations : 

Whenever the aggregate of acceptances outstanding at any- 
time (a) exceeds the amount of the subscribed capital and sur- 
plus, 50 per cent of all the acceptances in excess of the amount 
shall be fully secured; or (b) exceeds twice the amount of the 
subscribed capital and surplus, all the acceptances outstanding 
in excess of such amount shall be fully secured. The Corpora- 
tion shall elect whichever requirement (a) or (b) calls for the 
smaller amount of secured acceptances. 

Dollar exchange acceptances are not permitted to exceed 
fifty per cent of the banks' subscribed capital and surplus. 

Although the liability of the bank is only contingent in 
the case of a draft drawn under an acceptance credit, it 
seemed desirable to ensure a sufficiency of liquid assets 
against these acceptances. Accordingly, certain reserve 
provisions were inserted in the Regulations. 

Banks of this country displayed no immediate haste to 
take advantage of this authority to form such corpora- 
tions. In the early part of 1921 announcement was made 
of the formation of the Foreign Trade Financing Corpora- 
tion under the sponsorship of the American Bankers' 
Association. The capital of this corporation was to be 
^100,000,000. At that time there were only two other 
Edge Act corporations in existence. These possessed capi- 
tal stock of ?7,ooo,ooo and ?2, 100,000 respectively.^ 

Much difference of opinion exists regarding the future 
of such institutions. Lack of sudden growth may be ex- 
plained in part by the inevitable friction and delay in 
securing the large amount of capital such institutions 
would require. The depreciation of the dollar value of 
foreign currencies also rendered it uncertain to make ad- 
vances to foreign traders. The development of some such 

' See Report of the Federal Reserve Board for 1920, p. 26. 



i8o FEDERAL RESERVE POLICY 

plan of supplying international credits as the Ter Meulen 
may lessen the future need of Edge Act institutions. It has 
been anticipated, however, that the Ter Meulen bond 
would be issued to importers in foreign countries largely 
for the purposes of enabling them to obtain raw materials. 
The supplying of capital for such purposes as the purchase 
of machinery may establish a place for the Edge Act 
corporations. 

Full development of any institution of this sort must 
wait, however, in large measure upon the rectification of 
certain unsound financial practices employed at the pres- 
ent by European countries. As long as these countries 
refuse to balance their budgets and continue to meet 
deficits by new creations of currency, as long as credits are 
employed for non-reproductive purposes, as long as cur- 
rency inflation continues, relief to Europe will be difficult. 
But these corporations have another purpose than aiding 
in the reconstruction of Europe. A leading motive was to 
develop machinery whereby American financial institu- 
tions may be unhampered in meeting the legitimate re- 
quirements of foreign trade. 

As a concluding inquiry let us turn to the policy of the 
reserve banks in the endeavor to encourage the use of the 
acceptance. For the years 1915, 1916, and a part of 191 7, 
the discount rate on bankers' acceptances varied from two 
to four per cent. The Board sanctioned the application of 
minimum and maximum figures in order to permit reserve 
banks to differentiate according to their own discretion 
between paper of various degrees of solvency. In this early 
period the market for acceptances was largely that estab- 
lished by the reserve banks. The paper was new, and 
special discount corporations had not been formed to such 
an extent as to offer an immediate market for this paper. 
Accordingly, it was made possible for a very low rate to be 
applied. 



DEVELOPMENT OF BANK ACCEPTANCE i8i 

There is no doubt but that the reserve authorities were 
genuinely eager to encourage the use of this type of paper. 
Aside from any considerations thus far noted, acceptances 
would be expected to evoke a more intense foreign demand 
than that for any other grade of paper. With such a for- 
eign market created, it was hoped that it would be possible 
to shift the purchase from London to New York by alter- 
nate changes in discount rates. 

During 1917, however, the rates hardened. By the end 
of the year they had risen to 3 to 4 1/2 per cent, except for 
three reserve banks where the rates were 3 to 5 per cent. 
The latter part of the year open-market charges on bank- 
ers' acceptances maturing within 3 months were 4 per 
cent as a minimum. This was slightly less than the rates 
on 61-90-day paper secured by United States war obliga- 
tions (4 1/4 per cent). Relatively the same figures were 
maintained during the year 19 18. 

This lessening of the rate advantage given to the accept- 
ance may be explained on several grounds. First, 

It was thought that a lower rate for any class of paper than 
that borne by member banks' 15-day collateral notes secured 
by Government obligations might have an unfavorable effect 
upon the Treasury's operations.^ 

In other words, it was not desired to do anything which 
might interfere with the sale or the market for war securi- 
ties. Secondly, sufBciently good progress had been 
achieved in the acceptance movement to render less neces- 
sary an extremely low preferential rate. The increase in 
the open-market purchases by Federal Reserve banks is 
indicated by the following figures:^ 

1915 $ 64,845*000 

1916 386,095,000 

1917 909,301,000 

1918 1,809,539,000 

' Report of the Federal Reserve Board for 1918, p. 19. » Ibid. 



182 FEDERAL RESERVE POLICY 

Finally, money-market conditions during 191 8 were 
such as to render it unnecessary to endeavor to meet the 
lower British rate. Free shipments of gold were suspended 
and connection between the two markets was destroyed. 
The higher rate exacted here did not mean the driving of 
financing to London because of the disturbances wrought 
in foreign trade and finance. 

Since 191 8 the policy of the reserve administration has 
been to establish a greater similarity for the different 
classes of paper of corresponding maturities. On Decem- 
ber 21, 1 92 1, the average rates charged on bankers' accept- 
ances maturing within three months was the same as the 
commercial paper rate. Figures showing the purchases by 
reserve banks from 19 17 to 1920 were as follows:' 

ACCEPTANCES BOUGHT IN OPEN MARKET BY RESERVE BANKS 

I9I7 $ 909,301,000 

I918 1,809,539,000 

I9I9 2,825,177,000 

1920 3,218,364,000 

The holdings of reserve banks of bankers' acceptances 
on certain dates of 1920 and 1921 were as follows:* 



September, 1920 $306,295,000 

December, 1920 276,096,000 

March, 1921 132,106,000 

June, 1921 48,586,000 

September, 192 1 45,761,000 

These figures show a decided falling off in the acceptance 
activities of reserve banks during the year 1921. A similar 
decline is indicated by available figures bearing on member 
bank acceptance activities. Through inquiries sent out by 
the American Acceptance Council it was ascertained, in 

' Report of the Federal Reserve Board, 1920, p. 52. 
'Bulletin, November, 1921, p. 1269. 



DEVELOPMENT OF BANK ACCEPTANCE 183 

417 answers out of 482 inquiries, that bankers* acceptances 
outstanding on April i, 1920, amounted to as much as 
?799,ooo,ooo. By April i, 1921, this figure had shrunk to 
^644,000,000. Investigation of the Federal Reserve Board 
indicates an approximately similar decline for the same 
period.' 

Many factors serve to account for the decline in accept- 
ances in possession of reserve banks in 1921. The lessening 
volume of foreign trade and the fact that the preferential 
rate enjoyed by the acceptance has been virtually elimi- 
nated have retarded both the necessity and the desire of 
member banks to finance in this way. The general easing 
of the money market has enabled many banks, which 
would depend otherwise upon the acceptance, to finance 
their clients by the straight loan. At the same time, the 
improvement in the money market has enabled many 
banks to hold in their own portfolios acceptances pur- 
chased, until maturity. On the part of foreign branch 
banks there has been an increased competition with the 
reserve banks in the purchase of this paper. This latter 
fact would not concern, however, the operations of mem- 
ber banks. 

Despite these facts long-time prospects for the accept- 
ance development appear favorable. In some States, such 
as New York and Massachusetts, recent legislation per- 
mits savings-bank acquirement of acceptances. The 
Board's ruling in May, 1921, lengthening the maturity of 
eligible acceptances to six months, should render this 
paper more desirable for savings banks. As the period of 
depression gives way to activity, more and more situa- 
tions will arise in which customers' requirements will be 
too heavy to be met by direct advances. Education and 
propaganda, moreover, may accomplish much, and a 

» Bulletin, July, 192 1, pp. 775-76. 



i84 FEDERAL RESERVE POLICY 

great deal of work still remains for some reserve banks in 
lending their facilities to member banks in the purchase of 
acceptance paper. 

The future development of the acceptance market is 
highly necessary. Otherwise, surplus funds of member 
banks will again be entrusted in large volume to the call- 
money market. The call-money market is not under the 
direct control of the reserve system. Stock exchange paper 
is not eligible for rediscount or purchase. 



CHAPTER IX 

THE OPEN-MARKET OPERATIONS OF RESERVE 

BANKS 

In the mind of the public much confusion has existed 
regarding the difference between the open-market and dis- 
count operations of the reserve banks. The first class of 
operations are authorized by section 14 of the act, and the 
latter class by section 13. But in what way can a distinc- 
tion be made between the character of the work which can 
be performed under the authority of these two sections? 

A widely accepted belief has been that in the open-mar- 
ket operations the reserve banks deal directly with the 
public; whereas by their discount powers they operate 
only with the member banks. Color is lent to this view by 
noting certain facts about the early legislative history of 
the act. The report by Chairman Glass for the House 
Banking and Currency Committee on September 9, 1913,' 
contained the following statement: 

It [the committee] recommends that these bankers* banks 
shall be given a definite capital, and that they shall do business 
only with the banks aforesaid, and with the Government. 

The later inclusion of section 14 in the act is interpreted, 
therefore, as the extension to reserve banks of powers to 
deal directly with the public. However this may be, sec- 
tion 14 of the final bill authorized reserve banks to "pur- 
chase and sell in the open market, . . . either from or to 
demestic or foreign hanks,'"'' certain specified classes of paper. 

' House Report, 63d Congress, 1st Session, pp. 16 et seq. 
* Italics are the writer's. 



i86 FEDERAL RESERVE POLICY 

Under the terms of this section reserve banks may deal 
with banks. All that can be said for this point of view, 
therefore, is that the open-market powers are the sole 
authorization for direct dealings with individuals and cor- 
porations. Such powers are not granted by section 13. 
Section 14 also permits a reserve bank to deal with other 
than its own member banks. It may buy or sell certain 
types of securities and commercial paper from or to mem- 
ber banks in other districts. It cannot rediscount under 
section 13 for the member banks of other districts. 

Neither can complete distinction be found by noting 
whether there has been endorsement by the member bank 
of the paper offered the reserve bank. It is true that redis- 
counted paper must be endorsed by member banks, 
whereas the statute does not require paper purchased 
under the authority of section 14 to be endorsed. Never- 
theless, the Board has endeavored by its regulations to 
encourage the practice of giving precedence to endorsed 
paper in the reserve banks' open-market purchases. 

Nor can conclusive distinction be had by noting the types 
of paper which may be acquired under the authority of the 
two sections. It is true that certain types of Government 
securities and municipal warrants may be purchased 
under section 14 only, and that promissory notes 
can be acquired by reserve banks only by a discount 
authorized by section 13. The original bill permitted the 
open-market purchase of "notes, drafts, and bills of ex- 
change." But in the final draft the words "notes" and 
"drafts " were stricken out of section 14, although they are 
retained in section 13. But even after these alterations 
bankers' acceptances and bills of exchange could be dealt 
in by the authority granted by either section. Classifica- 
tion of securities and paper in the two sections overlaps. 

In the case of bank acceptances, however, nearly all the 



OPEN-MARKET OPERATIONS 187 

paper acquired from member banks has been in accordance 
with the authority granted by section 14. This is due to 
the fact that the rate on prime acceptances bought in the 
open market has been lower than the rediscount rate for 
commercial or agricultural paper. The principal exception 
to this statement relates to bankers' acceptances unen- 
dorsed by a bank or banker other than the acceptor. In 
this latter case the higher rate on rediscounted paper 
applies. 

If the paper is authorized by both sections and is ac- 
quired from a member bank, section 14 must be regarded, 
therefore, as conferring additional powers by which reserve 
banks may deal with member banks. As stated previously, 
however, the open-market regulations have been such as to 
discourage the applications of member banks involving 
paper not of the highest degree of liquidity. 

In view of the fact that the House Committee in its 
report of September 9, 1913, recommended that the bank- 
ers' banks must confine their dealings to member banks and 
the Government, it is peculiarly interesting to inquire into 
the motives which led to the inclusion of the open-market 
section in the final bill. It was understood, of course, how 
desirable such powers would be in enabling reserve banks 
to make profitable investment of their surplus funds. On 
occasions when the volume of rediscounting falls off, the 
earnings of reserve banks would diminish unless they could 
be permitted to go out in the open market and find invest- 
ment use for their funds. This consideration would hold 
for any central banking system. But the structure of the 
Federal Reserve was such as to render it peculiarly 
necessary that the district banks possess these powers. 
Member banks were compelled to subscribe to the stock of 
the reserve banks. Their interest and enthusiasm in the 
new system must pall unless a reasonable dividend is 



1 88 FEDERAL RESERVE POLICY 

received on stock subscriptions. At least, it is not desirable 
that reserve banks operate at a direct loss. 

Open-market operations, moreover, represent under 
some situations the only effective means whereby reserve 
banks can take aggressive action in the control of the money 
market. There can be no rediscounting unless the member 
banks take the initiative by making applications to the 
reserve banks. On occasions when member banks' reserves 
are plentiful, increase in rediscount rates may result in no 
correction of member banks' practices in advancing credits 
freely. Member banks may then ignore the advice and 
warnings of the reserve administration. Accordingly, if 
the reserve banks are to be more than a mere set of emer- 
gency institutions, they should be given power to effect 
general money-market conditions by their purchases or 
by their sales. Such measures are especially necessary in 
the endeavor to realize, first, more uniform rates through- 
out the country; and, second, to control the Nation's gold 
movements in such a way as to avoid excessive outflow at 
one period followed by enormous inflow in another. Direct 
sale and purchases are needed to accomplish the first result 
when banks in other districts are not attracted by the 
higher rates 'in the capital-poor sections. As a matter of 
fact, there have always been many obstacles in the way of 
the free flow of bank funds to the district of high rates. 
Rediscounting alone may not affect the situation markedly. 
In the matter of controlling gold movements, a principal 
past difficulty has been the inability of our many ex- 
change-dealing banks to adopt a unified policy regarding 
alterations in our discount rates as it appeared necessary 
to attract or to repel gold. No institution, furthermore, was 
charged with the responsibility of accumulating the supply 
of foreign credits which could be drawn upon in lieu of 
gold shipments in time of a declining exchange. 



OPEN-MARKET OPERATIONS 189 

Finally, it was anticipated that some of the open-market 
powers would prove very helpful in encouraging the use 
of dollar credits. If foreign countries are to be induced to 
employ dollar exchange as a means of international pay- 
ment, they must be satisfied that a ready market will exist 
in this country for the discount of the bills which their 
bankers and merchants draw. When the domestic market 
fails for prime bills of this sort, the reserve banks must 
protect it by their purchases. In opposite fashion, the 
institution responsible for the control of the Nation's 
gold movements should be given power to establish credits 
abroad which may be drawn upon in times when the 
balance of payment is unfavorable. Such drawings may 
make unnecessary shipments of gold. Accordingly, certain 
specified types of operations are permitted by section 14 
in order to accomplish this purpose. 

One aspect of this question is of peculiar importance 
in the establishment of the dollar exchange. This is the 
matter of quoting forward discount rates. As stated by 
Paul M. Warburg before the Pan-American Financial 
Conference : ^ 

A bank in a foreign country, when buying a dollar acceptance, 
must be assured of the rate at which the bill will be discounted 
when it reaches our country. On this rate it will largely depend 
whether the foreign shipper will use his European or his Ameri- , 
can credit facilities. The Federal Reserve banks are fully alive 
to the importance of this question, and I may state on behalf 
of some of the largest of these banks that they will be prepared 
to give the greatest possible assistance by adopting a liberal ^ 
policy in quoting such forward rates, good for a certain date or 
for delivery upon the arrival of mail by a given steamer. 

It seemed clear to the framers of the act that paper 
permissible for open-market dealings must be highly 
» Quoted from Btdletin, July i, 1915, pp. 132-36. 



190 FEDERAL RESERVE POLICY 

liquid. Purchases at one season or year become sales at 
another. Control of the market involves sales quite as 
much as purchases. It was insisted, therefore, that reserve 
banks should not buy large amounts of paper or securities 
which would not command a broad market in the period 
when it is desired to unload. 

It may seem strange, therefore, to note the inckision in 
section 14 of certain classes of investment paper. Through- 
out the act, the underlying theory appears to be that 
short-time paper growing out of commercial transactions 
is preferable to investment paper as an item in reserve 
banks' portfolios. It might seem as if investment paper 
would have been excluded in section 14 quite as throughly 
as in section 13. But there was the desire to make the 
Federal Reserve system of especial service to the Federal 
Government and the local subdivisions. Accordingly, 
by section 14, permission is given for investment in certain 
specified classes of Government securities. As a matter of 
fact, similar powers are granted by section 13. Therein eli- 
gible paper is made to include that drawn for the purpose of 
carrying or trading in bonds and notes of the Government 
of the United States. On purely financial grounds it might 
have been argued that Government securities frequently 
rise in price in time of extensive liquidation. The fear at- 
taching to private securities in period of liquidation seems 
often to increase the demand for Governments. These se- 
curities possess a more stable market than the general 
mass of obligations issued by private corporations. 

Paper purchasable under section 14 falls into four classes. 
We may mention first the Governments. Section 14b 
states that reserve banks may 

buy and sell, at home or abroad, bonds and notes of the United 
States, and bills, notes, revenue bonds, and warrants with a 
maturity from date of purchase of not exceeding six months, 



OPEN-MARKET OPERATIONS 191 

issued in anticipation of the collection of taxes or in anticipation 
of the receipt of assured revenues by any State, county, dis- 
trict, political subdivision, or municipality in the continental 
United States, including irrigation, drainage and reclamation 
districts, , . , 

Two facts in this sentence deserve emphasis. In the 
first place, municipal warrants must be issued solely in 
anticipation of later receipts. Fears as to the wisdom of 
including them may be mollified somewhat on this ac- 
count. In the second place, irrigation and reclamation 
districts are included in the class of governmental sub- 
divisions whose issues are purchasable under the authority 
of this section. There appears to be no attempt here to 
discriminate against agriculture or land-development. 

A second class of open-market paper consists of bills of 
exchange and bankers' acceptances. Need for these powers 
has been explained in previous chapters. The bankers* 
acceptance is peculiarly necessary for foreign-trade financ- 
ing and it was believed that its rapid development necessi- 
tated the sponsorship of central banking authority. 

An interesting question relates to the period within 
which purchasable bankers* acceptances must mature. 
This section empowers reserve banks to purchase and sell, 
in the open market, 

cable transfers and bankers' acceptances and bills of ex- 
change of the kinds and maturities by this Act made eligible 
for rediscount, . . . 

Since discounted paper, by the terms of section 13, 
must be payable within three months, it might appear as 
if purchasable bankers' acceptances must have no longer 
maturity. If this be true, it wouki be puzzling to under- 
stand the legal authority for the Board's Regulation B, as 
amended in May, 1921, wherein reserve banks are author- 



192 FEDERAL RESERVE POLICY 

ized to purchase bankers* acceptances arising out of 
foreign-trade transactions and having maturities as extended 
as six months.^ 

In reply to the writer's query on this matter the Board 
stated its position as follows: * 

The question of whether the Board's regulation authorizing 
the purchase of six-months' acceptances is in conflict with the 
terms of the Federal Reserve Act depends upon whether or not 
the phrase "of the kinds and maturities by this act made eligible 
for rediscount" refers both to bankers' acceptances and to bills 
of exchange or refers only to bills of exchange. It cannot, of 
course, refer to cable transfers, because cable transfers are not 
eligible for rediscount under any circumstances. The phrase 
might, however, qualify both bankers' acceptances and bills of 
exchange or might qualify only bills of exchange. The Federal 
Reserve Board has always interpreted it as applying only to 
bills of exchange, and in its regulations of the Series of 19 15, 
19 16, 19 17, and 1920, it has authorized the purchase in the open 
market by Federal reserve banks of acceptances growing out 
of the domestic storage of goods, although the only acceptances 
eligible for rediscount as growing out of domestic storage trans- 
actions are those growing out of the storage of readily market- 
able staples. The term "goods" is, of course, more inclusive 
than the term, "readily marketable staples." Consequently, 
the Board's Regulation B, Series of 1 92 1, making eligible for 
purchase in the open market, subject to certain conditions, 
acceptances with maturities not in excess of six months which 
grow out of foreign transactions, was not predicated upon any 
new interpretation of the law. 

Looking only at the language of this particular provision of 
the Federal Reserve Act, it is not clear whether the phrase 
"of the kinds and maturities by this act made eligible for re- 
discount" qualifies both bankers' acceptances and bills of 
exchange or qualifies only bills of exchange, but as heretofore 
indicated the latter interpretation now has the sanction of estab- 
lished usage, and this would, I think, have great weight with any 

' See supra, p. 174. 

' In a letter to the writer. 



OPEN-MARKET OPERATIONS 193 

court which had to pass upon the question. Furthermore, the 
legislative history of the Federal Reserve Act indicates that the 
Board's interpretation of the provision is the correct one. The 
corresponding paragraph of the bill as first passed the House of 
Representatives provided "That any Federal reserve bank 
may, under rules and regulations prescribed by the Federal 
Reserve Board, purchase and sell in the open market, . . . 
prime bankers' bills, and bills of exchange of the kinds and 
maturities made eligible for rediscount, and cable transfers." 
The words "and bills of exchange of the kinds and maturities 
by this act made eligible for rediscount" thus constituted one 
separate and complete clause with a comma at the beginning 
and at the end, and it is quite clear that the term "prime bank- 
ers' bills" was not intended to be qualified by the words "of 
the kinds and maturities by this Act made eligible for redis- 
count." There is nothing to indicate that the subsequent 
amendment which the Senate made in the phraseology of the 
provision was intended to give any broader application to the 
phrase "Of the kinds and maturities by this Act made eligible 
for rediscount," and the fact that the provision as thus amended 
is at least ambiguous is indicative of the absence of such intent. 

The last class of permitted open-market powers re- 
lates to dealings in cable transfers and gold coin and 
bullion. Section 14 states that reserve banks shall have 
power 

to deal in gold coin and bullion at home or abroad, to make 
loans thereon, exchange Federal reserve notes for gold, gold 
coin or gold certificates, and to contract for loans of gold coin 
or bullion, giving therefor, when necessary, acceptable security, 
etc., etc. 

These powers were conceived to be necessary in order to 
enable the reserve banks to exercise some control over the 
exchange market and to protect the dollar exchange. By 
acquiring foreign credits or accumulating gold holdings 
abroad the reserve banks may be able to provide American 
industry with the means of foreign payment on such 



194 FEDERAL RESERVE POLICY 

occasions as might otherwise result in a depreciation in the 
dollar or an excessive outflow of gold. 

The reserve system went into operation in a period 
marked by much confusion and uncertainty. In the haste 
to secure the functioning of the system it was not deemed 
essential that provision be made at the outset for the 
complete exercise of its open-market functions. Accord- 
ingly, 

the Board determined to confine itself in the beginning to those 
matters which were deemed absolutely essential to setting the 
banks in motion upon a basis of reasonable efficieHcy. It was 
felt that the regulations relating to discount operations and 
commercial paper in general were fundamental and they should 
be prepared and issued at once.^ 

Nevertheless, on December i8, 191 4, authority was given 
for the purchase of Government bonds. Shortly after- 
wards, December 23, regulations were sent out relating 
to the purchase of warrants and municipal bonds. Early 
in 1 91 5 regulations were issued relating to bankers' aC' 
ceptances, and by a 

letter of October 8, confirmed by a circular and regulation of 
December 6, the Board authorized the several institutions to 
purchase, at rates to be fixed by them within certain limits 
prescribed by the Federal Reserve Board, all those classes 
of bills of exchange which are by the Act made eligible for 
rediscount. 

Several points in these circulars deserve mention. The 
first relates to the purchase of acceptances. By Circular 19 
of November 29, 191 5, reserve banks were authorized to 
purchase domestic as well as foreign-trade acceptances. 
Since the act permitted national banks to accept only to 
finance transactions arising out of the importation or 
exportation of goods, the question may arise as to the 

' Report of the Federal Reserve Board, 1914, pp. 8-9. 



OPEN-MARKET OPERATIONS 195 

source of domestic-trade acceptances. The answer is 
that since the enactment of the Federal Reserve Act a 
number of States had adopted legislation permitting the 
domestic acceptance, and these were made eligible by the 
Board for purchase by the reserve banks. This action 
foretold the later advocacy by the Board of an amendment 
to the act permitting national banks to accept for domestic- 
trade purposes. If such action was not anticipated, the 
Board probably would not have made State bank domestic 
acceptances purchasable by reserve banks. It was also 
advocated in this circular that reserve banks should give 
preference 

to acceptances endorsed by a member bank, discounted under 
section 13, not only because of the additional protection that 
such endorsement affords but also because of the reason that 
acceptances discounted under section 13 may be used as col- 
lateral security for the issue of Federal Reserve notes. ^ 

Particularly because of the disturbed conditions abroad, 
the Board advocated caution in foreign-exchange dealings. 
While the Board did not insist that foreign bills of exchange 
should be accepted before purchase, it did rule that 
unaccepted bills either should be secured by documents or 
bear a satisfactory endorsement other than that of the 
acceptor or drawer. 

After the issuance of these circulars reserve banks were 
authorized to exercise to the full extent permitted the 
powers conferred by section 14. In view of the fact that 
the open-market section evidences more clearly than any 
other the intention of the framers that the reserve banks 
should operate continuously and not merely during emer- 
gencies, it is especially necessary to note the use which has 
been made of these powers. The following figures enable 

* Circular No. 20. By amendments to the original act acceptances purchased 
under section 14 may be used as collateral security for Federal Reserve notes. 



196 



FEDERAL RESERVE POLICY 



comparisons to be made between the volume of the discount 
and open-market operations by years from 191 5 to 1920: 





1 


2 


3 


4 


5 


6 


Year 


Total Bills 

Discounted 

FOR Member 

Banks 


Acceptances 
Bought in 
THE Open 
Market 1 


United 
States Secur- 
ities AND 
Municipal 
Warrants 


Total 

Investment 
Operations 


Per 
Cent 

OF 
1 TO 4 


Per 

Cent 

OF Open 

Market 

TO 4 


1915.. 
1916.. 
1917.. 
1918.. 
1919.. 
1920.. 
: : 


§ 161,353,000 

207,870,500 

9,014,186.454 

39.752.933.847 

79,173,969,730 

85,320,874,000 


$ 64.845.000 
386.095.000 
1,077,712.509 
1,809,538.795 
2,825,177,002 
3,218.364,000 


$ 81,572,770 

147,436,180 

105,421.882 

5,852.058.075 

4.737.920.421 = 

7,988,310,000 3 


$ 307,770.800 
741,401, 6>50 
10,197,320,845 
47.414.530.717 
86.737,067,153 
96,527,548,000 


52.4 
28.3 
88.3 
83.7 
91.3 
88.3 


47.6 
71.7 
11.7 
16.3 
8.7 
11.7 



I The first purchase of bankers' acceptances was made February 15, 1915. 
2 Includes only $1000 of municipal warrants. 
3 No purchases of municipal warrants. 

In the early years of operation, 19 15 and 191 6, the open- 
market operations were relatively very important. There 
was then little demand for discounts, and reserve banks 
were forced to make open-market purchases in order to find 
even moderate employment for their funds. In these years 
the reserve ratios of the reserve banks were very large. 
But after the outbreak of the European War the discounts 
requested by member banks were so great that open-market 
purchases declined in comparison. In aggregate volume, 
however, they increased year by year without interruption. 
In every year from 191 5 to 1920 the total volume of open- 
market purchases exceeded that of the previous year. 

One of the most interesting objections to the open-market 
provisions of the Reserve Act was voiced by Miss Anna 
Youngman in the September, 1921, number of the Amer- 
ican Economic Review^ She argued that it was a mistake 
to endeavor to discriminate against the promissory note in 
reserve banks' purchase operations. Our trade credit 
system is based upon the note and not upon the bill of 

* Pages 463-85. The Efficacy of Changes in Discount Rates of Federal Re- 
serves Banks. 



OPEN-MARKET OPERATIONS 197 

exchange, and attempts to foster the use of the bank ac- 
ceptance do not appear to her to have been exceptionally 
successful. She calls attention to the decline in the volume 
of bankers* acceptances in 192 1, and alludes to the fact that 
this decline would have been all the more startling were it 
not for the large volume of acceptance credits covering 
sugar and those granted for the creation of dollar exchange. 
Bankers' acceptances appear to her of principal value in 
foreign-trade transactions. Accordingly, the present open- 
market policy of the reserve banks is characterized as an 
attempt to secure effective control of the market by confin- 
ing dealings to a paper arising in a small and relatively un- 
important class of transactions. She advocates that reserve 
banks* open-market powers should be extended to include 
notes as well as bills growing out of commercial transactions. 
It also seemed plausible to her that, to a limited extent, 
reserve banks should be permitted to purchase, as well as 
discount, paper representing loans on stock exchange 
collateral. 

Miss Youngman's objection to great dependence upon 
the bankers* acceptance is also based upon her belief that 
the market for this paper is highly uncertain. There is the 
competitive English demand for bankers' acceptances, and 
the English rate must be met if the financing is to be done 
in the New York market. As long as acceptances grow 
largely out of international transactions, reserve banks 
must come to the rescue of dealers when the English rate is 
lowered, even though such action is contrary to our own in- 
vestment needs. Open-market transactions in commercial 
paper should be based more largely upon domestic paper. 

Her argument for extending reserve bank operations to 
stock exchange paper is based upon the belief that all money 
rates should be subject to influence, if not to control, by 
the reserve banks. Unless call rates can be influenced by 



198 FEDERAL RESERVE POLICY 

reserve activities, rates on other loans are also difficult to 
influence. To a certain degree banks have their choice in 
selecting the market which offers highest compensation. 
The reserve banks should be in a position to break abnor- 
mally high rates by direct lending. If they cannot do so, 
their rediscount policy may be rendered futile. 

The reader's reaction to these somewhat revolutionary 
views will depend largely upon the degree of control he is 
willing to repose at the present time in the reserve adminis- 
tration. Granted that the reserve banks can be managed 
impartially, with economic foresight, without fear of 
political hostility, the argument is entirely in favor of 
widening the classes of open-market paper. The greater 
the variety of paper which can be dealt in, the more com- 
plete the power of the reserve administration. Possibilities 
of evil are also greater. The reserve banks are governed by 
men, not by automatons. They have, or ought to have, 
personal interests to protect in the stock and investment 
market. No matter how great the endeavor to keep pri- 
marily in mind the needs of the public, personal responsibil- 
ities would tend always to create an unconscious bias. 
Aloofness from the stock exchange loan market is not an 
ideal situation, but it is perhaps the price that must be paid 
to limit plutocratic domination. 

On purely political grounds. Miss Youngman's pro- 
gramme is unworkable. Even at the present time, when 
direct advances on stock exchange security are impossible, 
there is a widespread belief that security speculation has 
benefited more largely than commxCrce or agriculture from 
the use of the reserve system's funds. The insistence upon 
an agricultural representative upon the Federal Reserv^e 
Board is one indication of this widespread belief. How 
much greater must have been the discontent with the 
reserve management if direct purchase of security paper 



OPEN-MARKET OPERATIONS 199 

had been permitted? The writer is convinced that the 
unpopularity of a system possessing such powers would 
have caused a complete remodeling of the system, possibly 
to the detriment of all classes, in the agricultural depression 
of 1920 and 1 92 1. Political considerations are quite as im- 
portant as financial. The present system is better than the 
old ; too much should not be expected of the reserve banks 
until the elementary principles of finance are more widely 
understood. Development cannot be too rapid. It is more 
desirable that slowly but soundly foundations be built for 
the more imposing edifice of the future. 

In regard to the inclusion of the note arising from com- 
mercial transactions the writer will agree that too much 
attention may have been reposed in the bankers' accept- 
ance. But the trade acceptance arising from domestic 
operations is eligible for purchase. In the past the popular- 
ization of the trade acceptance has encountered many 
obstacles. But part of the difficulties are due to the in- 
sistence that its progress should be sound rather than 
merely rapid. It might be better at the present time to 
admit the promissory note to open-market dealings. But 
many dangers would lie in such a course, and it appears the 
part of wisdom to postpone discussion of the admission of 
the note until the trade acceptance has had a more complete 
trial. Many will hold, furthermore, that the abuses of the 
open book-account system are sufficient to warrant some 
lessening of the reserve banks' powers. 

Miss Youngman's proposals are based largely upon her 
doubts as to the efficacy of changes in rediscount rates to 
affect general money charges. In many localities high loan 
rates will persist despite any lowering of reserve banks* 
rates. In such localities banking competition may be 
absent and the high charges represent some degree of 
monopolistic extortion. The only means of breaking such 



200 FEDERAL RESERVE POLICY 

rates lies in permitting reserve banks to step in as competi- 
tors of local banks by their direct purchases. But such 
action could be made effective only by permitting dealings 
in the type of paper customarily employed. Since the trade 
acceptance is unfitted for the needs of many buyers, it is 
argued that reserve banks should be permitted to purchase 
notes. 

Final conclusion upon this point must wait upon the dis- 
cussion of the relation of reserve banks* rediscount rates 
to those exacted in the general market.^ But it will be 
generally agreed, perhaps, that as a matter of public policy 
the present is not the time to introduce the reserve banks 
in the role of more active competitors of member banks. 
Present clamor directed against the reserve system is suffi- 
ciently great without adding this new source of discontent. 

During the World War a situation arose which led Sen- 
ator Robert L. Owen, then Chairman of the Senate Banking 
and Currency Committee, to propose the establishment of 
a separate reserve bank in order to relieve the other 
reserve banks of a portion of their responsibilities under 
section 14 of the act.^ This proposed new Federal Re- 
serve bank was to be charged with the responsibility of pre- 
venting the dollar exchange from depreciating abroad 
and with furnishing American commerce with the credits 
required in foreign transactions. If the plan which he 
advocated had been enacted into law, the regional charac- 
ter of our reserve system would have been altered to that 
extent. His bill proposed that in the field of international 
credits one new reserve bank should serve for all American 
industry and not primarily for any one district. 

The cause of Senator Owen's investigations was the 

^ See infra, pp. 339, 340. 

« Cf. H. L. Reed, "Senator Owen's Proposal to Stabilize Foreign Exchange 
Rates," American Economic Review, September, 1918, pp. 661-69. 



OPEN-MARKET OPERATIONS 201 

falling of the dollar below its normal gold par in some of the 
neutral countries of Europe, particularly Spain, Norway, 
Denmark, Netherlands, and Sweden. This depreciation 
occurred in spite of the fact that during the years 19 16 and 
19 1 7 the United States possessed a favorable trade balance 
with each of these countries as well as with the world at 
large. But credit extended by the United States to its 
European allies resulted in a plethora of dollar credits pos- 
sessed by merchants in these countries. When purchases 
were made from Spain by England, or France, payment was 
frequently made by drawing upon these dollar credits. 
Possessing a favorable trade balance with the world as a 
whole, Spain acquired more dollar credits than needed to 
balance its own requirements. Since shipments of gold 
were suspended, the dollar shrank in terms of pesetas. 

In many ways this depreciation of the dollar was un- 
welcome. As a matter of first importance, perhaps, it was 
argued that it rendered somewhat more difficult the cam- 
paign to assert the superiority of dollar credit as a medium 
of international payments. The supremacy of sterling ex- 
change in the past was due in no small measure to its 
stability in terms of gold. Here was the opportunity to 
establish the dollar as the one class of exchange which had 
not depreciated in the general financial confusion engen- 
dered by the World War. Nevertheless, for the reason 
given, the dollar declined in terms of the currencies of some 
of the countries with which the balance of trade was in our 
favor. 

The discount on the dollar abroad also increased the cost 
to our merchants who had remittances to make for their 
imports. A premium on the peseta of twenty-five per cent 
meant that, instead of the dollar buying five pesetas, it 
bought only four. But aside from any direct material loss 
the psychological effect of a falling dollar was held not to 



202 FEDERAL RESERVE POLICY 

be good. In normal situations a falling exchange points 
toward future gold withdrawals. The dollar exchange has 
fallen in most of our financial crises. Its depreciation dur- 
ing the World War could be pointed to by our enemies as 
evidence of our financial instability. 

Attempts on the part of private bankers to remedy this 
difficulty had been productive of little benefit. Private 
negotiations for the necessary loans in Spain had failed. 
Accordingly, Senator Owen proposed that the reserve 
banks should grapple with this problem. But as they were 
then constituted they lacked the machinery and powers 
necessary to secure effective results. No single one of the 
reserve banks was specified by the statute as responsible 
for the maintenance of the parity of the American dollar, 
and it would be impolitic to delegate this responsibility to 
any one. Charges of sectional discrimination would 
inevitably arise. It was asserted, furthermore, that each 
reserve bank was already so completely occupied with 
matters of domestic finance that it could not give the prob- 
lem of supplying foreign trade with the credits it required 
the necessary attention. 

Senator Owen proposed, accordingly, that 

the Federal Reserve Act be so amended as to provide for the 
establishment of ^a Federal Reserve foreign bank.* 

This bank would assume the responsibility of furnishing 
American Commerce with a stable exchange. It would 
have power to establish foreign branches generously 
equipped with power to acquire and sell foreign credits. If 
necessary these credits could be established in foreign 
countries by the sale of Government bonds. No individual 

» See remarks of Hon. Robert L. Owen on Senate Bill 3928 to establish the 
Federal Reserve Foreign Bank, etc., in the Senate of the United States, Febru- 
ary 25, 1918. Cong. Rec, pp. 2817-825. 



OPEN-MARKET OPERATIONS 203 

or bank other than this foreign bank would have the legal 
right to 

sell dollar balances at less than gold par, except as payment 
for merchandise imported into the United States, without the 
express authority of the Federal Reserve Board. ^ 

It would be directed by a board of nine men appointed by 
the President of the United States, and all of these would 
be merchants and not bankers. Bankers would be excluded 
from the directorate, for 

Our American bankers have not sufficiently realized that 
banking grows with commerce . . . the banker who thinks in 
terms of interest and commission and profit exaction is not 
happily constituted to determine the best methods of serving 
commerce. 

This would explain why reliance could not be placed on 
the recently established foreign branches of private banks. 
The proposed bank would be a reserve bank.^ 

This proposal met with some opposition from such men 
as Mr. Harding, and Mr. Warburg. Mr. Harding, for in- 
stance,^ felt that the situation was not sufficiently serious 
to justify the setting up of such elaborate machinery as was 
called for by Owen's plan. He did not feel that the tempo- 
rary dislocation of exchange with a few European neutrals 
would interfere with the campaign to encourage the use of 
the dollar exchange. The Orient and South America would 
not be affected directly by the discount on the dollar in 
these European nations, and it was in the Orient and South 
America that the best opportunity existed for encouraging 
the use of the dollar exchange. The continent of Europe 
would probably readopt earlier methods. 

* Cong. Rec, pp. 2817-825. 

« Ibid, 

3 Bulletin, August i, 1918, p. 724S . 



204 FEDERAL RESERVE POLICY 

The rather sudden termination of hostilities, bringing 
with it the ehmination of the dollar discount, seemed in the 
minds of most financiers to render Owen's machinery un- 
necessary. If the plan had been adopted, however, it would 
have marked the first departure from the regional idea. 
The writer ventures to remark that, if the regional plan is 
to be altered in the future, the opening wedge may prove 
to be some modification of the open-market powers. It is 
in the employment of these powers that the reserve banks 
can exercise their greatest initiative in the attempt to con- 
trol money-market conditions. 



CHAPTER X 
ADVANCES OF RESERVE BANKS — NOTE ISSUES 

The commercial bank creates credit or credit money of 
two forms, note issues and deposits. Although to-day both 
in Great Britain and the United States the deposits exceed 
note issues in volume and importance, early banking in 
both countries was primarily a matter of issuing notes. It 
is correct in the main to state that modem English banking 
found the germ of its development in the evolution of the 
bank note. The goldsmith's receipt of the fifteenth and 
sixteenth centuries, supposedly representing a value in 
coin or bullion equivalent to its face, gradually was adapted 
to the requirements of a circulating medium. In the course 
of time it was made payable to bearer and did not require 
endorsement when transferred to another party. It came 
to be made out in round even sums instead of to the 
amount representing the deposit of the owner. When ac- 
cepted by the public, even though issued to an amount 
exceeding its security, the trick of modem commercial 
banking had been learned. 

The issuance of circulating promises to pay exceeding 
the value of the coin or bullion security subjects the 
economic world to many dangers. Excessive issues of 
bank paper currency may produce the same results as the 
undue issue of Government paper money. The price 
level may advance rapidly to new heights, the gold of the 
country may be driven out as a consequence of the adverse 
trade balance engendered by the excessive issues, and if 



206 FEDERAL RESERVE POLICY 

non-redeemable an important element in the currency may 
depreciate. For these reasons attempts to restrict its issues 
would be expected. It might be argued, however, that 
unregulated deposits could create the same undesired re- 
sults. However this may be, note issues were developed 
before deposits, and the early dangers of uncontrolled 
banking were attributed largely to note issues. Accord- 
ingly, in English and American banking law, we find greater 
restrictions imposed upon banks in their note-issue powers 
than in their powers to create book credits subject to check. 

It may be that the discrimination against the note rests 
upon a sound economic basis. The note is payable to bearer 
and possesses a greater circulation power than the bank 
check. It may circulate for a considerable period far from 
the place of its issue. It may get into the pocket of an in- 
dividual who has no opportunity to learn of the solvency 
of the issuing bank. Because of its tendency to stay in 
circulation longer, the ability of the bank which issued it 
to redeem is not so speedily tested as in the case of the bank 
deposit. Since a check is not adapted for continuous cir- 
culation, a bank is automatically restrained from issuing 
too large a volume of deposit credits. So large an amount 
of checks drawn against it may be presented to the clear- 
ing house by other banks that a deficit in cash arises. But 
if the issue is a note, some time may elapse before the issu- 
ing bank is called upon to make redemption. The penalty 
may not be visited so speedily. 

At any rate, either because of these considerations or 
because of precedents established in the era of state bank- 
ing, or because of the historical fact that early banking 
abuses were largely note-issue abuses, the framers of the 
National Banking Act enacted the most rigid note-issue 
regulations. As finally amended the law rendered it im- 
possible for national banks to issue notes to an amount 



NOTE ISSUES 207 

exceeding the par or market value of Government bonds, 
whichever is the lowest, deposited with the Treasury to 
secure them. Basing note issues on the public debt made 
their inelasticity inevitable. Their volume tended to 
fluctuate more in accordance with the state of the bond 
market than with the needs of trade. Consequently plans 
of banking reform prior to the panic of 1907 usually took 
the direction of basing note issues more largely upon a 
wider class of bank assets. Commercial paper, in general, 
was to be the security instead of Government bonds. And 
while the Aid rich- Vreeland Act evidenced the influence 
of the opponents of an asset currency, provision was made 
for the issue of notes in periods of emergencies collateraled 
by a wider range of securities. 

Had bank note issues continued to occupy their old 
position of prominence the need of a more elastic bank 
note currency would have been uncontrovertible. But 
since the date of the writing of the National Bank Act 
the use of bank deposits has become relatively much more 
important. At the present time it is estimated that the 
check is employed as a means of payment in from eighty- 
five to ninety per cent of our total transactions. If deposit 
credits under the national banking system had possessed a 
large measure of elasticity, it would have been logical to 
attribute our currency ills primarily to the bank note. 
But, largely because of our rigid reserve requirements, de- 
posits also were insufflclently elastic. The case for an asset 
currency was not quite so clear as it otherwise would have 
been. 

These facts may be crudely Illustrated by noting the 
customary train of events in past periods preceding general 
collapse. As reserve ratios fall, banks become more and 
more hesitant to advance needed credits. The demand for 
loans becomes all the more intense as the market begins to 



208 FEDERAL RESERVE POLICY 

decline. By the time general public confidence is disturbed, 
runs upon banks may ensue. Since these runs represent a 
demand for currency, the inability of banks to expand 
their bank note issues freely appears to constitute the 
principal weakness of the banking system. But would the 
public demand for cash have arisen if at an earlier period 
banks had been permitted to expand their grants of de- 
posit credits in the necessary amount? 

There are many occasions when the demand upon a 
particular set of banks is primarily a demand for a circulat- 
ing medium. In the autumnal season of harvesting strain, 
crop-moving expenses could not be met by expanding 
deposits alone. Checks given to transient laborers, for 
instance, would be presented speedily to the banks for 
encashment. An enlargement of the volume of bank 
currency appeared the necessary requirement. But if re- 
serves against deposits had been less rigid, the difficulties 
created by the currency demands would not have been so 
intense. The currency would have been supplied at the 
expense of reserve money, but the penalty of slightly im- 
paired reserves would not have been so great. 

By the time the Federal Reserve Act was written, how- 
ever, these facts were more widely accepted. In the mind 
of the writer the principal point of progress marked by the 
Federal Reserve over previous plans is the greater recogni- 
tion of the need of elasticity of deposits. A thorough-going 
reform plan could not confine itself to an attempt to secure 
merely an asset currency. 

It was agreed nevertheless, that the ideal plan of reform 
would secure elasticity in bank note issues as well as in de- 
posits. Bank note currency provides a means of supplying 
the public with a circulating medium without impairing a 
bank's supply of reserve money. Elastic bank note issues are 
part of the problem of securing more flexible deposit credits. 



NOTE ISSUES 209 

These matters of elementary banking principle granted, 
the problem of banking reform became that of determining 
what set of banks should possess the bank note issue re- 
sponsibility. Should bank notes continue to be issued by 
the member banks or should their issue be concentrated in 
the hands of reserve banks only? Bearing in mind the fact 
that the reform movement was in part an attempt to secure 
greater concentration in credit control, it is not surprising 
to note the decision to concentrate the new bank note 
issuing powers in the hands of the reserve banks. The idea 
of centralized control was joined to that of greater elastic- 
ity in the media of exchange. 

It has been pointed out frequently that bank note issues 
are not absolutely essential to central bank operation. If 
its power to control credit be sufficient, the central bank 
may meet the demands upon it by accumulating in or- 
dinary times a surplus supply of reserve money to provide 
for seasonal or emergency needs. It is probably true, how- 
ever, that public confidence in a system without bank note 
issue powers would not be so great. Possessing such powers 
it appears as if the central bank's ability to manufacture 
the necessary media of exchange is incapable of exhaustion. 
As indicated previously, moreover, the general public has 
come to attach an exaggerated importance to bank note 
issues. 

But what should be done with the old bond-secured 
issues of national banks? There was much to offer against 
any programme of eliminating or subordinating these 
issues. They constituted a definite part of our money sup- 
ply approximating $750,000,000 and could not be with- 
drawn immediately without subjecting the country to a 
money famine. Furthermore, banks had purchased the 
bonds not so much for their investment yield as for the 
security of their bank note issues. This artifically created 



210 FEDERAL RESERVE POLICY 

demand caused the price of the bonds to move to a higher 
point than warranted by their income return. Because of 
the circulation privilege attaching to its bonds, the United 
States has been able to borrow money at cheaper rates than 
almost any other country in the world. In the pre-war 
period, while the United States two per cents, bearing the 
circulation privilege, were selling at about par, British two 
and a half per cent consols were selling only slightly above 
seventy, and French three per cent rentes at about eighty- 
five. Justice demanded that the Government take no action 
confiscating bond values bought in good faith. 

In order to reconcile the legitimate interests of the banks 
with the requirements of commerce for a more elastic 
currency a means was provided by the act for the gradual 
purchase from the national banks of a portion of their 
bonds by the Federal Reserve banks. By the terms of 
section i8 any member bank desiring to retire any of its 
circulating notes is permitted to ''file with the Treasurer 
of the United States an application to sell for its account, 
at par and accrued interest. United States bonds securing 
circulation to be retired. " Such applications can be made 
in the twenty-year period, December, 1915, to December, 
1935- At the end of every quarterly period the Treasurer 
of the United States is required to furnish the Federal 
Reserve Board with a list of such applications. The Board 
may require the reserve banks to purchase these bonds, 
which are then to be apportioned among the twelve reserve 
banks pro rata according to their relative capital and 
surplus. It was provided that the reserve banks could not 
be compelled to purchase more than ^25, 000,000 of these 
bonds in any one year, and that this amount must include 
whatever amount of bonds the reserve banks may have 
purchased directly from the public without the inter- 
vention of the Federal Reserve Board. 



NOTE ISSUES 211 

In this manner provision was made for the eventual 
acquirement by the reserve banks of bonds bearing the 
circulation privilege and the gradual retirement of the 
bank notes outstanding against them. The reserve banks 
were authorized to utilize these bonds in one of two ways. 
First, they may deposit them with the Treasurer of the 
United States and upon this security issue bank notes to 
the par value of the bonds. The law stated that such 

notes shall be the obligations of the Federal reserve bank 
procuring the same, and shall be in form prescribed by the 
Secretary of the Treasury, and to the same tenor and effect as 
national-bank notes now provided by law. 

In case, however, no vital need exists for this currency, 
the bonds may be converted into one-year gold notes or 
three per cent thirty-year old bonds not possessing the 
circulation privilege. Such an exchange is to be made on 
the basis of par and accrued interest. If this method is 
availed of, the bond-secured bank notes may be reduced 
gradually in volume. But this reduction may be very slow, 
since reserve banks cannot be required to purchase more 
than ?25, 000,000 of these bonds in any one year. But at 
any rate provision was made for a reduction relative to the 
volume of other currencies. As the country grows in 
population and resources and the other elements in the 
circulation increase, the bond-secured bank notes will 
decline in importance. 

The extent to which the reserve banks have availed of 

these provisions in order to issue their own bond -secured 

currency is indicated for certain selected dates by the 

following figures : 

Federal Reserve Bank Notes in Circulation 

Amount Outstanding 

January 4, 191 8. . $ 8,000,000 December 31, 1919 $273,450,800 

June 28, 1918. . . . 10,390,000 December 31, 1920 249,467,000 

December 27, 1918 117,122,000 November i, 192 1 123,296,960 



212 FEDERAL RESERVE POLICY 

Without further information it might appear as if the 
reduction in national bank circulation, particularly in the 
years 191 8 and 19 19, must have been exceedingly heavy. 
This would seem to follow from the fact that the reserve 
bank notes were required to be secured by Government 
bonds, and that the surrender of these bonds to the reserve 
banks must compel a reduction in national bank currency/ 
But the figures show no such reduction in national bank 
circulation. At the close of 192 1 it was approximately the 
same as in 1914 and had increased somewhat since 1917. 
Thus: 

Total Volume of National Bank Notes Circulating in the 

United States 

July I, 1917. . . $7i5;420,oio January i, 1919. . 3723.532,210 

January I 1918 719,212,630 January i, 1920. . 724,338,692 

July I, 1918. . . 724,205,485 November i, 1921 743,288,847 

Clearly the increase in the volume of Federal Reserve 
bank notes was not at the expense of the aggregate circu- 
lation of national bank notes. To what, then, can the in- 
creased circulation of reserve bank notes be attributed? 

During the World War the attention of Congress was 
drawn to the uses which might be made of the stock of 
silver dollars reposing in the Treasury of the United States. 
Several Oriental countries were accumulating balances 
against the United States and our allies and it was not de- 
sired to meet these claims by exporting gold. So far as 
silver could be used economically for this purpose, it would 
seem that the Treasury's stock should be drawn upon. 
For years this stock had been lying idle as the metallic 
backing for the silver certificates. 

Accordingly, by the Pittman Act of April 23, 1918, the 
Secretary of the Treasury was authorized to melt down 

^ Unless offset by the purchase of other bonds possessing the circulation 
privilege. 



NOTE ISSUES 213 

and sell as bullion not more than ^350,000,000 standard 
silver dollars. The bullion could be sold for the following 
purposes: first, to conserve the Nation's stock of gold; 
secondly, to facilitate with silver-using countries the 
settlement of adverse trade balances; thirdly, to provide 
silver for subsidiary coinage or domestic use. In order to 
protect the silver market it was provided that the bullion 
should be sold at a price of not less than $1 per ounce of 
silver 1000 fine, and that the silver thus withdrawn must 
be repurchased by the Treasury at the same price. Since 
the melting down of the silver dollar would destroy the 
security for the silver certificates, it was provided that 
these certificates should be retired at the rate oi $1 for 
each dollar melted down or broken up. 

This would involve a reduction in one of the elements 
in our currency. In order to prevent a corresponding 
contraction in the general circulating medium the Federal 
Reserve Board was given authority to require reserve 
banks to issue Federal Reserve bank notes to an amount 
not exceeding the amount of standard silver dollars thus 
destroyed. The reserve banks issuing these were required 
by law to deposit as security United States certificates of 
indebtedness or one-year United States gold notes. 

The amount of Federal Reserve notes thus issued under 
the terms of the Pittman Act was as follows on certain 
dates: 

Up TO AND 

Including 

December 31, 1918 $110,803,000 

December 31, 1919 259,375,000 

December 31, 1920 260,875,000 

The Pittman Act was regarded merely as a temporary 
measure. Section 6 required that, as the silver dollars are 
recoined through the purchase of silver bullion by the 
Secretary of the Treasury, Federal Reserve bank notes 



214 FEDERAL RESERVE POLICY 

shall be retired in an amount equal to the volume of the 
dollars so coined. Such purchases of bullion must be 
made at the rate of ?i an ounce. On April i, 1921,^ it was 
announced by the Secretary of the Treasury that the re- 
tirement of Pittman Act certificates had been begun and 
would be continued gradually. 

The Pittman Act proved decidedly useful during the 
war and post-war period. It seems unfortunate, however, 
that the Treasury was required to repurchase the amount 
of silver obtained by melting down the dollars. Securing 
silver certificates by silver coin or bullion is an anomaly 
in a gold-standard country. The real security for any of 
our currency, gold, could have been obtained on favorable 
terms by the final sale of the silver bullion at the highest 
market silver has commanded in years. We lost our oppor- 
tunity to work off without great loss our silver, the exist- 
ence of which had really been a source of embarrassment in 
previous years. But it may have been politically unwise 
to estrange the silver interests during the period of 
hostilities. 

But no progress in elasticity was made by the issues 
of Federal Reserve bank notes. It was by the means of 
another note creation, the Federal Reserve note, that the 
endeavor was made by the Act of 19 13 to provide the truly 
elastic element in our currency system. These notes are 
the issues of reserve banks upon the security of commercial 
paper, and each note bears the distinctive number of the 
district in which it is issued. 

By the terms of the original act the method of issue was 
as follows: Any reserve bank could make application to 
the Federal Reserve Agent — the member of the district 
directorate who is the ofhcial representative of the Federal 
Reserve Board — for such amount of the notes as it may 

* See Bulletin, April, 1921, p. 374. 



NOTE ISSUES 215 

require. Such applications must be accompanied by a 
tender of collateral equal to the amount applied for. By 
the original act the collateral offered in the application 
must be notes and bills accepted by the reserve bank for 
rediscount. But the act was later amended in such a way 
as to include In the collateral paper purchased in the open 
market. Section 16 now states that 

the collateral security thus offered shall be notes, drafts, bills 
of exchange, or acceptances [acquired] under the provisions 
of section thirteen of this act, or bills of exchange indorsed by a 
member bank of any Federal reserve district and purchased 
under the provisions of section fourteen of this Act, or bankers' 
acceptances purchased under the provisions of said section four- 
teen, or gold or gold certificates. 

The Federal Reserve Board can at any time call upon the 
reserve bank for additional security. 

These notes were made receivable by all members and 
reserve banks. They are obligations of the United States 
and are receivable for all taxes. They are not legal tender 
for private payments. They may not be counted as a part 
of the legal reserve of a member bank. Whether or not they 
may be counted as reserve money by a State bank depends 
upon law In that State. 

The first line of security behind these notes is the com- 
mercial paper (gold in lieu of paper) deposited with the 
Federal Reserve agent. Reserve banks must also main- 
tain a forty per cent gold reserve behind these notes. This 
requirement, however, may be suspended by the Federal f 
Reserve Board. But If the reserve Is permitted to fall below fj 
forty per cent, a graduated tax paid by the reserve bank 
will operate as a penalty. 

These notes will be issued to member banks through the 
process of rediscount, and offer a means whereby reserve 
banks can supply the member banks with counter money 



2i6 FEDERAL RESERVE POLICY 

without depleting their own reserves. Since they are 
issued through rediscounts, prevention of excessive issues 
becomes a part of the problem of rediscount policy. Rate 
increases, more careful scrutiny of the paper offered by 
member banks, direct refusals, represent the means of pre- 
venting unduly large issuance or of compelling their 
retirement. 

But what means were provided to secure their speedy 
return on occasions when the need has passed ? The follow- 
ing devices were included in the Federal Reserve Act. 
First, the notes of one reserve bank may not be paid out 
by another reserve bank save by paying as a penalty a 
ten per cent tax upon the face value of the notes. A mem- 
ber bank however, located within or without the district 
of issue may pass them out without restriction. Since a 
Federal Reserve note may circulate for a long time before 
being deposited with a reserve bank, this provision cannot 
be expected to do much in the way of compelling their 
quick redemption. Secondly, the notes may not be 
counted as a part of the legal reserves of any member 
bank. A member bank in need of reserve money will be 
impelled, therefore, to save them for redemption. But on 
other occasions of ample reserves member banks may not 
find it necessary to establish their reserves by the redis- 
count method. In this situation the return of the notes is 
not likely to be rapid. Finally, the notes are issued only 
upon the deposit with the reserve agent of commercial ' 
paper. If the reserve banks are rediscounting freely, 
ample paper should be available to replace the collateral 
upon its maturity. But if the reserve banks refuse or dis- 
courage renewals, they may compel member banks to 
return the notes or their equivalent in other currency. 

There is no doubt but that the act provides ample 
means for redemption in cases where redemption is 



NOTE ISSUES 217 

desired. They must be received by any member bank and 
by any reserve bank; if they reach the counter of another 
reserve bank, they may be collected either directly from 
the reserve bank of issue or indirectly through the Gold 
Settlement Fund at Washington. But while there is an 
open avenue for rapid redemption, nothing short of a 
strict rediscount policy is likely to result in their being 
driven home against the will of the holder. They may get 
into the vaults of State banks which are permitted to 
count them as reserve money, they may repose in the tills 
of merchants or pockets of the people, they may form part 
of the counter money reserve of member banks. Only one 
situation is likely to explain their return against the will 
of the holder, that in which they are acquired by another 
reserve bank than that which issued them. Expansion of 
these notes in time of need is easy, but whether or not 
there is to be contraction in slack season and years depends 
upon the rigor with which the reserve management exer- 
cises its powers of rediscount control. 

Mention should be made, however, of a provision in the 
act which gave the Federal Reserve Board power to exact 
from the reserve bank an interest charge on all notes 
issued to the reserve bank not covered by gold or gold cer- 
tificates in the hands of the agent. The purpose of this 
provision was to give the Board some power in the way of 
compelling contraction. Reserve banks compelled to meet 
such a charge would likely exert, by means of higher rates, 
pressure upon member banks to return the notes or their 
equivalent in other money. In case, however, the reserve 
bank directorate was working in close harmony with the 
Board, and did not endeavor to thwart the Board's advice 
to restrict rediscounts, such pressure would not be re- 
quired. The writer is not aware that a tax of this sort has 
yet been imposed upon reserve banks. 



2i8 FEDERAL RESERVE POLICY 

In the early period of its existence the volume of re- 
discounting by reserve banks was exceedingly limited. 
Nevertheless, a rather large amount of notes got into cir- 
culation. Since the notes are issued to member banks 
through the process of rediscounting, the public was at 
first somewhat puzzled at the existence of so large an out- 
standing circulation. On analysis, however, it developed 
that notes once issued were not being retired upon the 
maturity of the paper rediscounted. Instead of returning 
the notes to the agent, the reserve bank would deposit 
gold as ''cover." Reserve banks, when called upon by 
member banks for currency, would offer the Federal 
Reserve notes instead of gold. In this way the notes were 
becoming virtually gold certificates. 

A few figures will indicate the extent to which this prac- 
tice was carried on. On July 2, 191 5, the total amount of 
notes issued to the reserve banks was ^84,000,000. As 
security for these the Federal Reserve agents held lawful 
money to the amount of ?70,ooo,ooo. On June 30, 191 6, 
the amount of note issues was ?i 76,000,000. ?i65,ooo,ooo 
of the cover for this was lawful money. On June 29, 1917, 
J402, 000,000 of the security for ^550,000,000 of notes was 
legal tender money. In other words, the accumulation of 
cash in the hands of the reserve agents was chiefly cash and 
only to a limited extent paper. 

This policy of the Federal Reserve Board was bitterly 
condemned in certain quarters. The Commercial and 
Financial Chronicle, for instance, asserted vigorously^ 
that there was no authority for keeping the notes out- 
standing in this manner, and that the plain intent of the 
^^ law was to secure their retirement upon the maturity of 
their paper collateral. Furthermore, the Board was 
charged with usurpation of authority. The act did not then 

» Issue of August 7, 1915, pp. 398-400. 



NOTE ISSUES 219 

permit notes to be issued to reserve banks by the deposit 
of gold with the agent. But the Board was accomplishing 
virtually this result by, first, issuing the notes on commer- 
cial paper security, and then, upon the maturity of the 
paper, making gold the cover. In reality, urged the Chron- 
icle, the Board was breaking the spirit of the law. 

Those closely connected with the management of the 
reserve system did not hesitate sharply to defend this 
policy. Governor Strong, of the New York Reserve Bank, 
denied vigorously that the Board was exceeding its 
authority.' If it had been intended that the notes should 
represent only paper, a simple provision could have been in- 
serted in the act to that effect. It was clearly the purpose 
of the act that the notes should become a part of the gen- 
eral circulation and the policy of the Board was designed 
merely to hasten this result. Furthermore, the impound- 
ing of gold meant no inflation, but, on the contrary, a 
restriction of bank credit. For neither by reserve banks 
nor by member banks could the notes be counted as 
reserve money. 

As the law then stood there can be little question as to 
the correctness of Governor Strong's views. The deposit 
of gold cover with the reserve agents did not restrict the 
possibilities of credit expansion. But the law was subse- 
quently amended in many ways, with the general result 
of increasing the ability of the reserve and member banks 
to expand their deposits. The Chronicle was correct in 
surmising that the practice of impounding gold as cover 
was a forerunner of many later events the general trend of 
which was to alter radically the working of the system. In 
the development of these plans it was incidentally neces- 
sary to create a larger field for the circulation of the notes. 

These subsequent events will be discussed in the foUow- 

« Issue of August 7, 1915, pp. 412-13. 



220 FEDERAL RESERVE POLICY 

ing chapter. They can be treated best in connection with 
certain amendments altering the reserve requirements for 
member banks deposits. To-day the Federal Reserve note 
is the most important element in our general circulation. 
Its supremacy over other moneys can be noted by examin- 
ing the following figures:^ 

Money Held Outside the United States Treasury and the 
Federal Reserve System, November i, 192 i 
Gold coin (including bullion) . .$ 373456,004 

Gold certificates 189,141,549 

Standard silver dollars 38,837,297 

Silver certificates 211 ,351 ,466 

Subsidiary silver 259,176,773 

Treasury notes of 1890 1,554,164 

United States notes 265,413,018 

Federal Reserve notes 2,446,481,946 

Federal Reserve Bank notes . . 102,363,172 
National bank notes 719,196,681 

At the present time the national bank note is dwarfed 
by the Federal Reserve note. Even though the national 
bank issues aggregate an amount somewhat comparable 
to that of 19 14, they have become relatively unimportant. 
Their place has been seized by the new Federal Reserve 
note. But whether or not the new note is to be truly 
elastic, whether or not it is to display the qualities of 
contractility, is dependent mainly upon the discount 
policy adopted by the Federal Reserve management. 

» Obtained from the Bulletin, December, 192 1, p. 1495. 



CHAPTER XI 

ADVANCES OF RESERVE BANKS— DEPOSITS AND 
RESERVES 

In the preceding chapter it was remarked that the move- 
ment in this country for banking reform took first the 
direction of attempts to secure an asset currency. The 
plan formulated by the American Bankers' Association 
in 1894, known as the Baltimore plan, may be interpreted, 
for instance, as a direct attack on the bond-security 
theory. According to this plan it was proposed to permit 
the issue of bank notes by national banks secured by 
commercial assets. Protection for the noteholder would 
consist of : first, the prior lien upon the assets of the failed 
bank; secondly, restriction of bank note issues to a certain 
percentage of the capital stock; thirdly, the double lia- 
bility of stockholders. The plan may be regarded, there- 
fore, as an attempt to ensure the safety of the bank notes 
by relying upon other requirements than the deposit of 
Government bonds. But it disregarded totally the prob- 
lem of securing a more elastic deposit currency. 

It may appear as if a similar disregard of the importance 
of deposit currency was displayed in the Aid rich- Vreeland 
Act of 1908. It could be asserted, for instance, that the 
panic of 1907 had demonstrated clearly that the principal 
difficulty of our banking machinery was the concentration 
of the reserves of the interior banks in New York City. 
Because of certain misuses of these funds the deposits 
could not be withdrawn. After the default of the New 
York depository banks, substitutes for money, such as 



222 FEDERAL RESERVE POLICY 

clearing house loan certificates, had to be devised. In 
many localities they were believed to have brought relief. 
What was accomplished under the Aldrich-Vreeland Act 
was to make regular provision for the issue of emergency 
currency under the regulation of the Federal Govern- 
ment. This act did not attempt to go to the root of the 
difficulty. It contained nothing to prevent future diffi- 
culties of a similar sort from again arising. It was purely 
palliative and not surgical. 

But despite its apparent necessity the matter of revising 
our deposit machinery was a difficult task. It would seem 
to involve the prohibition of the employment in the finan- 
cial centers of interior bank deposits for the purpose of 
supporting stock market loans. Plans which contemplated 
such restrictions must arouse a great deal of opposition. 
It was easier to confine efforts to the securing of an asset 
currency. Such efforts could be made to appear solely in 
the light of concessions to the banks. They would be 
given powers which previously were denied. But by the 
time of the Wilson Administration public opinion had 
crystallized itself more definitely. The country had begun 
to understand that any reform which reached the roots of 
previous difficulties must do something more than merely 
to provide for emergency note issues. It also must alter 
old methods relating to the employment of bank reserves. 

As a final result of the legislative endeavors culminating 
in the Federal Reserve Act, four leading provisions were 
enacted regarding the reserves of member banks. First, 
it was stipulated that after three years nothing could count 
as reserve for any member bank except cash in its own vault 
or deposits with the reserve bank of its district. This did 
not mean that member banks would be prohibited from 
keeping deposits with other than the reserve institutions. 
Banks in the interior could continue to keep deposits with 



DEPOSITS AND RESERVES 223 

big city banks in any amount desired for purposes of 
domestic exchange and the securing of whatever interest 
such deposits would command. The only prohibition of the 
act related to the use which could be made of these deposits. 
They no longer could be counted as a part of the required 
legal reserve for the depository banks.^ 

Secondly, the act reduced considerably the amount of 
the reserve percentages. The theory accepted was that with 
reserves massed in central reservoirs the same protection 
could be furnished the depositor with a smaller amount of 
reserve money. It was a matter of realizing the economies 
of reserve concentration. As a result of this reduction it is 
estimated that in 19 14- 15 an economy of four or five hun- 
dred millions of dollars was effected. 

Thirdly, it was provided that the transfer of money from 
private correspondent banks in the central reserve cities 
to the Federal Reserve banks might be gradual. The law 
stated that the transfer must be completed within three years 
after the establishment of the Federal Reserve bank in the 
district in which the bank was located. A specified amount 
of the reserve must be transferred to the district reserve 
bank immediately, another specified portion at the end of 
the year, and later installments at semiannual intervals. 

The purpose of these provisions was to effect the transfer 
of reserves without subjecting the stock market to a sudden, 
severe shock. Banks in the central reserve cities were to be 
permitted gradually to make the necessary rearrangements 
in their loan position. It was hoped that some progress 
might be made in establishing the custom of financing 
sharply fluctuating securities by time instead of by call loans. 

Lastly, the act stated a distinction between demand de- 

* Exception could be made to this statement during the period prior to the 
completion of the process of transferring reserve money from central reserve 
cities. 



224 FEDERAL RESERVE POLICY 

posits and time deposits. Deposits subject to immediate call 
necessarily require a larger reserve than those withdrawable 
only after the expiration of a certain period of time. As to 
the distinction between demand deposits and time deposits 
a paragraph of section 19 stated that 

Demand deposits within the meaning of this Act shall com- 
prise all deposits payable within thirty days, and time deposits 
shall comprise all deposits payable after thirty days, and all 
savings accounts and certificates of deposit which are subject 
to not less than thirty days' notice before payment. 

These reserve requirements for member banks under the 
original act may be represented by the following scheme : 

1. Banks in the Central Reserve Cities (New York, Chicago, St. Louis). 

18 per cent demand deposits and 5 per cent time deposits. 

(a) In own vault 6-18. 

(b) In reserve banks of its district 7-18. 

(c) Balance optional with the bank. 

2. Banks in Reserve Cities. 

15 per cent demand deposits, 5 per cent time deposits. 
( (a) 5-15 in own vaults. 
After three years ■< (b) 6-15 in reserve bank. 
( (c) Balance optional. 

3. Country Banks. 

12 per cent demand deposits, 5 per cent time deposits, 
(a) 4-12 in own vault, 
(b 5-12 in reserve bank, 
(c) Balance optional. 

Four methods were provided by which deposits could be 
established with the reserve bank. First, lawful money 
might be remitted. Secondly, checks or other items might 
be forwarded for collection to the reserve bank. (In a pre- 
ceding chapter account has been made of the gradual de- 
velopment of this work. At the present time the reserve 
banks receive for collection daily an enormous volume 
of cash items as well as of time items.) Thirdly, commercial 
paper might be rediscounted according to the terms of sec- 



DEPOSITS AND RESERVES 225 

tion 13. Lastly, certain types of paper or securities specified 
by section 14 might be sold directly to the reserve bank. 
But how far could the reserve banks go in granting mem- 
ber banks book credits? This would depend upon the vol- 
ume of reserve money possessed by reserve banks. Section 
16 states that 

Every Federal reserve bank shall maintain reserves in gold 
or lawful money of not less than thirty-five per centum against 
its deposits. . . . 

Since the establishment of the reserve system the mini- 
mum reserve percentages for reserve banks have been 
unchanged. But those for member banks have been altered. 
Let us next endeavor to find explanation for these 
alterations. 

Although the provisions of the act created a reduction in 
the aggregate volume of reserves, the new arrangements 
were not altogether satisfactory to the member banks. 
Many of their criticisms were unsound ; nevertheless, their 
general effect was to prepare the way for a change. The 
first criticism was purely the result of a misunderstanding. 
It involved the belief that member banks would not be 
permitted to keep deposits in banks other than the district 
reserve banks. This view was, of course, erroneous. The act 
prohibited only the counting of such deposits as reserve 
money. 

Secondly, it was asserted frequently that in reality the 
act increased reserve requirements. Many banks argued 
that they would be forced for exchange or other purposes to 
keep deposits with city correspondents as well as with the 
reserve banks. The two deposits combined might exceed 
those customarily maintained under the old law. 

Reply to this was that since the reserve banks would 
make collections on checks and other items and credit these 



226 FEDERAL RESERVE POLICY 

to the account of the forwarding bank, deposits in other 
banks for collection purposes would be necessary no longer. 
In the beginning, however, there was some doubt as to how 
completely the reserve banks would function in these mat- 
ters. Would the reserve banks give immediate credit for the 
remittance of checks drawn against non-member State 
banks? Would they collect time as well as demand items? 
Would their service charge be unduly high? These, at first, 
were matters of doubt. Some time must elapse before 
reserve banks could demonstrate that in every feasible 
way they would endeavor to perform the services previously 
rendered by the correspondent banks of the financial centers. 

But even though reserve banks would perform these 
services, they could not pay interest on deposits. In the 
past, city banks were willing to make collections, receive at 
par checks drawn against the bank, as well as pay interest 
on the balance. The reserve banks would pay no interest. 

This objection, however, overlooked the savings effected 
through the reduction in the amount of the reserve required. 
Suppose, for instance, that the country bank had outstand- 
ing before the establishment of the new system ? 100,000 of 
demand deposits. The minimum reserve for this would be 
? 15,000. Three fifths of this amount, or ?9000, might be 
carried as a balance with its city correspondent. The year's 
interest on this amount at 2 per cent would be $180. This 
appeared to be a direct loss. 

But under the new arrangement the required reserve 
would be ?i2,ooo instead of ?9000, or a saving of feooo. If 
this could be invested to realize 6 per cent, the interest would 
cancel entirely the apparent loss of ?i8o. 

In the matter of the "float, " finally some member banks 
felt themselves harshly treated. In an early chapter men- 
tion was made of the loose practices formerly permitted by 
the Comptroller according to which country banks could 



DEPOSITS AND RESERVES 227 

establish reserves. Checks drawn against outside banks 
would be dispatched to the city correspondents and im- 
mediately considered as reserve money. Under the clearing 
plan finally worked out by the Reserve Board, distantly 
drawn checks would not be credited to the account of the 
forwarding bank until sufficient time had elapsed in which 
to make collections. Despite the logic and the necessity of 
this practice, many banks asserted that they were being 
harshly treated. 

Whether or not these complaints alone would have se- 
cured any concessions for member banks cannot be as- 
certained definitely. But it happened that the plans of the 
reserve administration were such as to lend its influence to 
the lowering of reserve minima. The endeavor of the admin- 
istration was to devise a means of gaining control of a larger 
portion of the country's gold. The natural method of accom- 
plishing this result would be to require member banks to 
keep a larger portion of their reserves with reserve banks 
than that law at first compelled. But it was understood that 
this could be brought about only by lessening the amount 
which must be kept in the banks' own vaults. Since it was 
felt that the concentration of reserve money under the 
control of reserve banks would be a more economical use of 
reserve money, the final outcome was a reduction in the 
aggregate legal minima. 

It is easy to understand the importance ascribed by the 
reserve management to the accomplishment of the purpose 
of accumulating the Nation's gold more largely in the vaults 
of reserve banks. Such gold would form the basis for a much 
larger issue of Federal Reserve notes or of book credits to 
member banks. The war in Europe resulted in an enormous 
inflow of gold to America and there was no assurance that 
after the war there would not be an outflow of similar pro- 
portions. In order to guarantee our ability to meet any 



228 FEDERAL RESERVE POLICY 

post-war demands, it would be desirable to have it under 
the control of the Board, which was supposed to keep the 
general public needs foremost in mind. Then again the 
disregard of neutral rights had gone so far in the European 
conflict that it was not at all certain whether the United 
States could continue to assume an inactive role. If war 
should come, the demands upon our banks would be heavy. 
A much greater expansion of credits would be possible if 
the gold was lodged in reserve banks' vaults. 

As expressive of the views of one member of the Federal 
Reserve Board the following remarks may be quoted from 
an address of Paul M. Warburg:^ 

We are faced with the simple question: Will we be strong 
enough to share our plenty, during the coming period of stress, 
with other nations and be the world's banker, or will we be so 
weak that, when these demands come, we must stop them at 
once by raising our discount rates high enough to retain our gold 
at home? Keep all the gold in your vaults, gentlemen, where it 
is useless for yourselves and deprived of the additional force that 
it may gain in the hands of the federal reserve banks ; keep every 
cash till in hotels, railroad stations, dry goods stores and what 
not, filled with gold certificates, and you will rob the country 
of its legitimate opportunity of growth, of helping itself, and 
of helping the world. Our foreign competitors will proclaim that 
only a country willing to part freely with its gold may safely 
be accepted as a world's banker, and they will point to the fact 
that in past critical periods, our banks stopped paying in gold. 
It is our duty to give the world an overwhelming evidence of our 
ability and determination in the future to maintain our gold 
obligations under any and all circumstances. 

A discussion of the measures employed by the reserve 
administration to accomplish this purpose forms one of the 

* Delivered before the American Bankers' Association at Kansas City. See 
Journal of the American Bajikers' Association, October, 1916, pp. 307-19. Cf. 
also address by A. C. Miller, another member of the Board, delivered before 
the Indiana Bankers' Association. Ibid., November, 1916, pp. 385-90. 



DEPOSITS AND RESERVES 229 

most interesting chapters in financial history. At the incep- 
tion of the new system, it was not clear what machinery 
could be employed to bring under the Board's control any 
large amounts of gold. The act required member banks ^ 
to make payments for their capital stock subscriptions in 
gold. Member banks must also keep a portion of their 
reserves with reserve banks, but the final transfer of re- 
serves from reserve or central reserve cities would not be 
completed for three years. These reserves might be estab- 
lished partially, moreover, by rediscounts and not the 
remittance of specie. Altogether these measures would 
bring the reserve banks only a small portion of the Nation's 
gold. Accordingly, the ingenuity of the Board hit upon the 
previously mentioned device ^ of impounding gold as cover 
for note issues. By this means a large quantity of gold was 
got into the hands of the reserve agents. But this gold was 
immobile. It must remain as collateral for the Federal 
Reserve notes, and could not be employed to support further 
issues of notes or deposit credits extended by reserve banks. 
But for the time being the Board was obliged to confine 
its efforts to the substitution in the general circulation of 
Federal Reserve notes for gold, and to the accumulation 
of this gold in the hands of the agents. In this connection it 
is interesting to read a letter sent by the Board on Septem- 
ber II, 1916, to the various district banks. It had developed 
that one of the reserve banks had been meeting the currency 
requirements of its members by shipments of gold certifi- 
cates. Gold certificates could be obtained a little more 
cheaply than the Federal Reserve notes. Section 16 states 
that 

The plates and dies to be procured by the Comptroller of the 
Currency for the printing of such circulating notes shall remain 

'Section 2. 

« See supra, Chapter X, pp. 217-219. 



230 FEDERAL RESERVE POLICY 

under his control and direction, and the expenses necessarily 

incurred in executing the laws relating to the procuring of such 
notes, and all other expenses incidental to their issue and retire- 
ment, shall be paid by the Federal reserve banks . . . 

The Board, however, requested the reserve banks to ignore 
their desire to save a small expense and to issue, instead, 
whenever possible Federal Reserve notes, 

thereby helping to concentrate gold certificates in the vaults of 
the Federal Reserve banks. ^ 

But to what extent would member banks be willing to 
receive Federal Reserve notes? If their need was for re- 
serve money, they could return the notes to the reserve 
bank and demand redemption. But for counter money 
purposes the notes would be as good a currency as any. 
They would be acceptable also by such State banks as were 
permitted to count them as reserve money. 

Nevertheless, there were limits to the willingness of mem- 
ber banks to absorb the notes. They would not be ac- 
ceptable when held in excess of the amount necessary for 
till money and when legal reserves were low. Accordingly 
the Board began to move for changes in the act which would 
create a wider field for the Federal Reserve note circulation. 
It proposed an amendment which would permit reserve 
banks to issue Federal Reserve notes directly against the 
deposit of gold with the Federal Reserve agents. This sug- 
gestion was rejected by Congress together with another 
proposal that the Federal Reserve notes should be made 
legal reserve money for member banks. But in the amend- 
ments of September 7, 19 16, it was enacted that 

Upon the affirmative vote of not less than five of its members 
the Federal Reserve Board shall have power, from time to time, 
by general ruling covering all districts alike, to permit member 

* Bulletin, October i, 1^16, p. 512. 



DEPOSITS AND RESERVES 231 

banks to carry in the Federal Reserve Banks of their respective 
districts any portion of their reserves now required by section 
nineteen of this Act to be held in their own vaults. 

The Board ruled immediately (September 8, 19 16) ^ that un- 
til further notice 

any member bank so desiring shall be permitted to carry in the 
Federal Reserve Bank of its district any portion of its reserves 
now required by law to be held in its own vaults. 

This amendment did much to increase the willingness of 
country member banks to transfer their deposits from city 
reserve agents to reserve banks. It tended also to render the 
Federal Reserve notes more acceptable. A member bank 
possessing a sufficient amount of credits on the books of its 
reserve bank need not worry about the kind of money in its 
own vaults. For counter-money purposes the notes were 
as good as gold. 

But helpful as this amendment was, its accomplishments 
were negative so far as rendering any outright advantage 
to member banks was concerned. Shifting reserves to re- 
serve banks would not increase the member bank's loaning 
power. If the member bank did not heed the Board's implor- 
ations, it would not be subject to penalty. Accordingly, the 
Board pressed for a change in the law which would make 
compulsory what previously had depended entirely on the 
discretion of the member bank. Success crowned its efforts 
by the enactment of the amendment of June 21, 19 17. This 
amendment stated that thereafter member banks must hold 
their legal reserves entirely on deposit with reserve banks. 
The only legal reserve would be credits on the books of the 
reserve banks. Of course the member bank would be ob- 
liged to keep on hand a supply of money for payments over 
the counter. But the amount of this till money would 
depend upon the discretion of the member bank. 

^Bulletin, October i, 1916, p. 508. 



232 FEDERAL RESERVE POLICY 

According to one of the Board's earlier suggestions to 
Congress, the percentage of till-money reserve would be 
definitely stated by law. Leaving the matter entirely to the 
discretion of the member bank, therefore, may be regarded 
as a step toward the abolishment of the rigid reserve require- 
ments of the earlier days. 

There has been a disposition on the part of some banks 
to insist that this amendment increased rather than de- 
creased the real reserves required of member banks. This 
argument was based upon the fact that the requirements of 
the new law made no mention of till money. Whatever 
amounts must be kept for payments over the counter must 
be added to the legal requirements. But even with this 
addition the writer's investigations lead him to believe that 
for all the banks of the country there was a considerable 
reduction. At any rate, as will shortly be explained, the abil- 
ity of reserve banks to rediscount for member banks was 
increased by this measure enormously. Member banks 
establish reserves by rediscounting. They were benefited 
by the terms of this amendment. 

The percentage of member banks* net deposits which 
must be held as credits with the reserve banks has been as 
follows since the amendment of June 21, 19 17. 

FOR DEMAND DEPOSITS FOR TIME DEPOSITS 

Banks in central reserve cities . . 13 3 

Banks in reserve cities lO 3 

Banks in all other cities 7 3 

In the opinion of the writer this amendment is by far the 
most important which has been superimposed upon the 
original act. Occurring shortly after our entrance into the 
World War, it rendered absolutely certain the ability of our 
banks, for the time being at least, to guarantee the success 
of the Treasury's bond sales. It made possible a pyramid- 
ing of credits unexampled in the history of banking. It 



DEPOSITS AND RESERVES 233 

contained great possibilities of good as well as of evil. The 
expansion of credit which has taken place since 19 17 is in 
large measure due to the working of the amendment of 
June, 1917. 

Let us now endeavor to explain how efficient gold in the 
possession of reserve banks has become in furnishing a 
basis for member banks* deposit credit advances to the 
business public. First, let us view the situation from the 
standpoint of the country bank. Taking into account only 
demand deposits and assuming no till money to be neces- 
sary, ^24. 50 of lawful money in the possession of the re- 
serve bank would permit a country bank to extend ?iooo 
of deposit credits to its clients. The ^24. 50 would be the 
35 per cent reserve for the $']0 of book credits granted by 
the reserve bank to the member bank. This $"jo would be 
the member bank's 7 per cent reserve for ?iooo deposits 
granted one of its customers. In other words, a dollar of 
legal tender currency lodged in the vaults of a reserve 
bank would enable a country bank to loan more than ^40 
of deposit credits. 

This same sort of pyramiding of reserves existed under 
the old national banking system. But then the utmost 
that could be done was to enable the country bank to loan 
S 13 for a dollar of reserve money lodged in the vaults of a 
central reserve city bank. The old reserve percentage for 
country banks was ?iooo. Fifteen per cent of ?iooo= 
?I50. Of this, ?90 might be held as a deposit with a re- 
serve city bank whose minimum reserve was 25 per cent. 
Twenty-five per cent of ?90=?22.50. Half of this ^22.50, 
or ?ii.25, might be held as a deposit credit on the books 
of a central reserve city bank which must keep a straight 
25 per cent reserve. Twenty-five per cent of ? 11.25 is 
?2.8i; ?6o plus ?ii.25 plus ?2.8i is ?74.o6; ?iooo divided 
by 274.06 is 13 plus. 



234 FEDERAL RESERVE POLICY 

Let us now view the situation from the standpoint of 
the reserve city bank. Under the old system pyramiding 
of reserves could go to a point where ?iooo of its deposit 
could be backed by ?i 56.25. The reserve city bank's 25 
per cent reserve for ?iooo is ^250. Half of this might be 
kept in the form of a deposit with a central reserve city 
bank whose reserve must be 25 per cent. Twenty-five per 
cent of ?I25 = ?3I.25; ?3i.25 plus ?I25 = ?I56.25. In 
other words, the real reserve minimum was 15.6 per cent. 

After the amendment, however, the actual reserve for 
this class of banks need be only 3.5 per cent; 10/100 of 
?iooo of 35/100= ?35. In central reserve city banks a 
straight 25 per cent reserve was required. Now it need be 
only 4.55 per cent; 13/100 of ?iooo of 35/ 100 =^45. 50. 

Some allowance, however, should be made for the mem- 
ber bank's till-money requirements. Let us assume that a 
counter-money reserve of 5 per cent would be sufficient, 
and that this be composed entirely of Federal Reserve 
notes. Behind these notes the reserve bank must keep a 
40 per cent gold reserve. Forty per cent of 5 per cent is 2 
per cent. Two per cent, therefore, should be added to the 
percentages given above. 

But, even after making this addition, it will be per- 
ceived that a dollar of gold or lawful money in the posses- 
sion of the reserve bank was rendered extremely efficient 
in supporting member bank advances. Our reserve mech- 
anism after June, 1921, was very similar to the English 
system wherein the reserves of private banks consist 
largely of credits on the books of the Bank of England. 
But the English custom was the result of a long and slow 
development. Never before was a currency measure 
enacted which enabled banks on the moment to multiply 
so enormously their grants of credit to the business public. 

Not only was gold becoming more efficient as reserve 



DEPOSITS AND RESERVES 235 

money, but the inflow of gold to this country prior to the 
amendment had been enormous. In a few years the net 
inflow was more than a bilHon dollars. If this gold could 
be got into the reservoirs of the reserve system, the power 
of the new system would be established once for all. Here 
was an opportunity of centuries and the reserve manage- 
ment did not overlook it. In every possible way the en- 
deavor was made to substitute notes for gold certificates 
in the general circulation, and to accumulate the gold in 
the reserve banks' vaults. 

One difficulty in accomplishing this purpose resulted 
from the fact that the Federal Reserve notes could not be 
issued in sufficiently small denominations. The act 
limited these issues to denominations of $S and above. It 
was impossible under these circumstances to keep the 
notes circulating in as large a volume as otherwise might 
be accomplished. When the need was for money in small 
denominations, the Federal Reserve notes would be pre- 
sented for redemption. The problem was thus to over- 
come the difficulty created by the large denominations 
of the notes. 

Partial solution for this difficulty, however, was found 
by an act passed on October 5, 19 17, which was designed 
to create a larger field for the circulation of the notes. To 
quote the Bulletin on this matter: " 

The passage of the act of October 5, 1917, authorizing national 
banks to issue not more than $25,000 each in denominations of 
$1 and $2 and authorizing them to issue notes of $5 on the same 
basis as other denominations is intended to provide a larger 
volume of small bills. The Treasury Department, as is well 
known, has for some time past been converting large green- 
backs or United States notes into notes of small denominations, 
thereby probably finding a permanent field of circulation for 
them. As the greenbacks thus move out of the larger and into 
^Bulletin, November i, 1917, pp. 833-34. 



236 FEDERAL RESERVE POLICY 

the small denominations, an increasing field for Federal Reserve 

notes is opened. The Treasury, Federal Reserve Board, and 
the Federal Reserve Banks are consistently cooperating in 
substituting Federal Reserve notes for the circulation of gold 
certificates, and they are effectively supported in this under- 
taking by the national banks and those of the State banks and 
trust companies which have joined the system. 

Various other devices were being employed in the mean- 
while to discourage the issuance of gold into the general 
circulation. By the fall of 19 17 the banking law of New 
York State had been amended so as to permit State banks 
and trust companies to count Federal Reserve notes as 
part of their vault reserves.' In the securing of such 
statutes various associations of bankers played an impor- 
tant role. April 10, 19 17, the executive committee of 
the American Bankers* Association at a meeting in New 
York resolved : ^ 

That this committee urgently recommends to the trust com- 
panies of the United States that immediate steps be taken to 
secure amendments, where necessary, to the State laws in order 
that the trust companies may be permitted to carry their gold 
reserves on deposit with the Federal Reserve Banks in their 
several districts, and that as soon as such action can be legally 
taken, the trust companies offer to deposit these reserves with 
the Federal Reserve Banks. 

In its issue of January 29, 19 19, the Chicago Tribune con- 
tained an announcement of the position of the Subtreasury 
of Chicago and the Federal Reserve bank of that city. It 
was stated that the Federal Reserve notes bear the words : 

This note is redeemable in gold, on demand, at the Treasury 
Department of the United States in the City of Washington, 
or in gold or lawful money ^ at any Federal Reserve Bank. 

Accordingly, the Subtreasury and the bank were within 

^Cf. Commercial and Financial Chronicle, August 25, 1917, pp. 760-61. 
3 See Bulletin, May i, 1917, p. 335. 
3 Italics are the writer's. 



DEPOSITS AND RESERVES 237 

their legal rights in suggesting that the party who wanted 
gold could go to Washington to get it. They announced 
that they themselves would not pay out a single gold coin 
for any purpose whatsoever. 

By such methods as these the reserve notes were made 
to take the place in the general circulation of the legal 
tenders so that the latter could be available for the re- 
serves of reserve banks. But prior to June 21, 19 17, the 
law relating to the collateral securing reserve notes was 
such as to limit the possibilities of substituting notes for 
gold. When the collateral originally securing Federal 
Reserve notes matured, gold would be deposited with the 
Federal Reserve agent, and the notes would be retained 
for reissue to the member banks. This gold could not be 
counted as a part of the reserve for deposits. Accordingly, 
the effectiveness of the policy of impounding gold as cover 
for the notes was limited. 

This difficulty was lessened, however, by the amend- 
ment of June 21, 19 1 7, which paved the way for a still 
greater expansion of bank credits. Prior to this amend- 
ment, money deposited with the Federal Reserve agent 
as cover for the notes could not be counted as part of the 
reserve for deposits. But after this amendment, gold 
deposited with the agent as security for the reserve notes 
could be counted as a part of the reserve bank's 40 per 
cent gold reserve for notes. This would enable other gold, 
which previously had been earmarked as the note reserve, 
to support a larger volume of book credits granted to 
member banks. The limit was further removed within 
which note issues might restrict reserve banks' power to 
create money deposits for member banks. 

By such legal and administrative measures the reserve 
management had answered with finality the question of 
its future power and influence. The gold holdings of 
reserve banks became steadily larger, and more and more 



238 FEDERAL RESERVE POLICY 

banks became members of the system. The expansive 
power of our credit structure was increased wonderfully. 
In later chapters figures will be given regarding the 
amount of increase in credit advances to member banks 
rendered possible by these measures.^ But enough has 
been presented to indicate that, as a result of the admin- 
istrative and legal changes culminating in the amendment 
of June 21, 19 1 7, the working of the reserve system was 
altered definitely. 

One or two matters of banking technique may now be 
considered briefly. The first relates to the method of 
computing member banks' reserve percentages. Specifi- 
cally, what was the law's definition of net deposits to 
which the reserve percentages applied? To answer this 
we can do no better than to quote from an Opinion of 
Counsel in the Law Department in the Bulletin : ' 

Member banks, in determining the amount against which 
reserves must be carried, may deduct all Government deposits, 
except postal savings' deposits,^ and may deduct from the 
amount of balances due to other banks the amount of balances 
due from bank checks drawn on banks located in the same place 
and exchanges for clearing houses. The law, however, does not 
permit member banks to deduct checks on other banks located 
in the same place or exchanges for clearing houses from gross 
demand deposits, nor does it permit cash on hand to be deducted 
from gross demand deposits. 

In a later chapter certain information will be given 
regarding the determination of the reserve banks' reserves 
for deposits granted member banks. 

*See infra, Chapter XIV. 'Bulletin, September i, 1917, p. 692. 

3 Bulletin, June i, 1917, p. 458. This exemption of Government deposits was 
the result of an act approved April 24, 1917. While the prime purpose was to 
assist in financing the war, the law referred to all Government moneys and not 
merely to the proceeds of bond sales. The purpose was in part to enable the 
Treasury to keep as long as possible, to the advantage of the local banks, funds 
in the localities which supplied them. 



CHAPTER XII 

FEDERAL RESERVE DEVELOPMENT, NOVEMBER, 
1914, TO DECEMBER, 1916 

In each of the preceding chapters attention has been 
focused upon some one aspect of Federal Reserve opera- 
tion. The problems confronting the reserve management 
cannot be well presented, however, by employing this 
method alone. It is necessary that we understand the 
relation of each project to the others in the gradual devel- 
opment of Federal Reserve policy. For this purpose we 
have divided the life of the reserve system into four 
periods. The first period, extending from November, 
1914, to December, 1916, was primarily one of organiza- 
tion-development and preparation for future emergencies. 
The second period, January, 1917, to May, 1917, is char- 
acterized chiefly by two facts. First, the reserve banks 
by their discount and purchase operations were beginning 
to secure some degree of effective control over the money 
market; and, secondly, the reserve system was being made 
ready to bear the financial strain of the war that began to 
appear more and more imminent. In the third period, 
June I, 19 1 7, to November 11, 19 18, the management was 
absorbed in the task of cooperating with the Treasury in 
meeting the problems of war finance. The fourth period, 
extending from the armistice to the spring of 1920, may 
be characterized as that of post-war credit and trade 
expansion. The final period concerns the relation of the 
reserve system to business and industry in the depression 
of 1920-21. 



240 FEDERAL RESERVE POLICY 

The Federal Reserve Act became law December 23, 
19 1 3. It provided for the appointment of an Organization 
Committee composed of the Secretary of the Treasury, 
the Secretary of Agriculture, and the Comptroller of the 
Currency. Among this committee's duties was the map- 
ping out of the country into the various districts, each to 
be served by a reserve bank. After this work was com- 
pleted, the committee served notice upon the national 
banks of the country to subscribe to the capital stock of 
the new banks. As soon as a sufficient amount of capital 
was guaranteed in this way, the formalities were begun 
of granting corporate life to the reserve banks and pro- 
ceeding with the election of directors for the district 
boards. In the meanwhile the President was engaged in the 
task of appointing the members of the Federal Reserve 
Board. In this some delay was encountered. President 
Wilson had announced that in the selection of the Board 
he did not wish suggestions of the sort usually offered in 
the making of appointments. He appeared to be convinced 
that the selection of a strong personnel was of the utmost 
importance to the Nation. But after his nominations were 
made, some further delay was caused by the action of the 
Senatorial Banking Committee in holding up, on the 
ground of their business affiliations, the appointments of 
Mr. Warburg and Mr. Jones. Mr. Warburg refused to 
submit to cross-examination by the committee. His nomi- 
nation, however, eventually was confirmed.^ 

In these ways the spring and summer of 19 14 slipped by, 
and it seemed that the opening of the reserve banks for 
business must be postponed until the spring of 19 15. But 
in the meanwhile the European conflict broke out, creating 
such financial disturbances as to cause to be reconsidered 
the question of the date of operation. 
' Cf., Commercial and Financial Chronicle, July 11, 19 14, pp. 91-92. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 241 

The nature of the upset to the Nation's finances 
created by the sudden outbreak of hostilities is now thor- 
oughly familiar to the general public. In a very brief 
period European security exchanges were closed and New 
York became the world's dumping ground for a great mass 
of internationally owned securities. This sudden selling 
pressure induced such weakness in the securities market 
that to prevent the collapse of bank credit exceptional 
action was taken. New York followed the lead of Paris 
and London and closed to trading the country's leading 
securities exchange. 

In a number of ways this upset in stock market circles 
occurred at a very inopportune time. A large block of 
New York City Subway notes held by foreign capitalists 
was about to mature, and, moreover, there had been the 
usual drawing of finance bills in the pre-autumnal period 
to provide a portion of the funds for the moving of the 
crops. The expectation was that these bills would be 
covered out of the proceeds of agricultural exports sub- 
sequent to the fall harvesting period. 

For the time being, however, there was a virtual stop- 
page in the export trade and a cessation of active trading 
in some of the leading articles of commerce. Some time 
was required for the English and French navies to clear 
the sea lanes of German raiders, and it was understood 
that foreign countries must economize wherever possible 
in the consumption of American products. Food products 
were necessaries, however, and it is interesting to note that 
throughout the emergency the Produce Exchange of 
New York as well as the grain exchanges remained open 
and did an enormous business. It was perceived that the 
European purchase of food products could not long be 
postponed. But the leading product of an entire section 
of the country, cotton, could not be moved, and its price 



242 FEDERAL RESERVE POLICY 

declined in a very brief period from twelve or thirteen to 
seven or eight cents a pound. No basic article of agricultural 
production is financed more largely by credit than cotton. 

Under these circumstances all sorts of plans were 
conceived to relieve the strain upon the Southern banks. 
The "Buy-a-Bale-of -Cotton" movement was launched and 
projects were formulated involving loans upon cotton 
evaluated by semi-governmental agencies at prices higher 
than existing quotations. These plans came to naught, 
but Northern Bankers were induced to pool their resources 
by organizing a cotton loan fund. 

Gold could not be shipped until the sea lanes were made 
safe, and, moreover, there was displayed a general dis- 
inclination of American bankers to let gold go out of the 
country. With the cessation of gold shipments sterling 
exchange moved far above the normal export point. 

It was felt generally that these adverse conditions could 
not continue indefinitely. It was expected that European 
demand for cotton must finally renew itself, the resump- 
tion of export selling would lessen the demand upon our 
gold, the quieting of conditions in European financial 
centers would lessen the likelihood of reckless security 
dumping and make safe the opening of our exchanges. 
But despite this undercurrent of confidence the shock was 
of almost unprecedented severity. It is generally believed 
that the banking system of 1907 would have succumbed 
quickly in this crisis. 

Fortunately the Aldrich-Vreeland Act was available to 
provide legal sanction for the issuance of bank notes 
secured by other collateral than Government bonds. It 
will be recalled that the terms of this act were such as to 
permit of these notes being issued without much formality. 
Banks were empowered to organize into associations and 
the issues would be protected by the collective collateral 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 243 

of the association. In August the act was amended by 
Congress in such a way as to enable the issuance of these 
bank notes to a larger proportion of the banks' capital 
than at first authorized. Altogether something like 
?38o,ooo,ooo of emergency currency notes were put out.^ 
In many of our cities also large volumes of clearing house 
certificates were issued. As additional measure of relief 
the Secretary of the Treasury adopted some rather 
extraordinary measures. Mr. McAdoo took the position 
that in a situation so grave, a situation, moreover, in 
which the provision for emergency issues existed, no bank 
was justified in refusing legitimate demands of its cus- 
tomers for credit. Consequently, publication was begun 
of a so-called blacklist in which were stated the names of 
banks whose reserves were extraordinarily large. Possibly 
because of the aid rendered by such measures the credit 
stringency was prevented from becoming acute. 

It was undoubtedly unfortunate that the reserve 
system was not in operation at the time of the crisis. It 
provided for a reduction in reserves somewhat comparable 
to the total amount of Aid rich- Vreeland notes and clearing 
house certificates issued.^ With its note-issuing powers 
there would have been little doubt of its ability to meet all 
legitimate demands. With the reserve banks operating, 
many of the emergency measures, such as the Cotton 
Loan Pool and the Foreign Exchange Fund, would have 
been unnecessary. If the stock exchange could have been 
kept open, our willingness to pick up at bargain prices the 
securities of frightened European holders would have been 

* Cf. Report of the Federal Reserve Board, 1914, p. 15. 

'According to figures based upon the Comptroller's call of September 12, the 
reduction would be $464,919,076. This makes no allowance, however, for the 
duplication and triplication of items under the old law. The real cash reduction 
would be considerably less. Vice-Governor Delano's estimate of the actual 
reduction was $250,000,000. (Cf. Commercial and Financial Chronicle, Novem- 
ber 2 1 , 1914, p. i486.) But at any rate the psychological effect was good. 



244 FEDERAL RESERVE POLICY 

one of the strongest indications of our financial power. If 
gold exports could have been maintained freely, Withers' 
would not have found opportunity for chiding New York 
at becoming panic-stricken at her first opportunity of 
supplanting London as the world's banker. He would not 
have been able to assert that a temporary little difficulty 
in Lombard Street threw Wall Street into utter confusion. 
The reserve banks could have furnished all the relief of 
the emergency measures without outward confession of 
the existence of strain. 

It was felt, however, that it would be a mistake to begin 
the operation of the reserve banks until its organization 
was more complete. Inability to function properly might 
lessen permanently the prestige of the new system. Some 
difficult readjustments, moreover, would be occasioned 
by its establishment. For one matter, the transfer of 
reserve funds from the banks of the central reserve cities 
to the Federal Reserve banks might create some acuteness 
in the financial centers. But in a short period financial 
conditions became less disturbing. By the end of August 
it was noted that the emergency currency notes were 
being returned in large quantities and there was less dis- 
cussion of plans involving the valorization of cotton. 
Money rates in the financial centers began to ease, and on 
the last Saturday of October the New York Clearing 
House report showed that the reserve deficiency which 
had existed since the outbreak of the European war had 
been replaced by a substantial cash surplus. The demand 
for funds, moreover, began to lessen under the influence 
of reduced speculative activity in the stock market. 
Accordingly, toward the close of October the Secretary 
of the Treasury announced that all of the twelve reserve 
banks would begin operation November i6. 

« Cf. Hartley Withers, War and Lombard Street, pp. 98-1 ii. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 245 

The time of their opening was thus synchronized with 
the restoration of activity in the export trade. Accord- 
ingly, the return to normal conditions was rapid. The 
first week in December tradings under a minimum price 
were resumed in the New York Stock Exchange, and 
shortly thereafter all restrictions were removed. The 
emergency issues continued to come in for redemption. 

In the haste to get the reserve banks into operation 
they were not equipped at first with full power. The Board 
was able to issue regulations covering only such operations 
as were deemed essential to their functioning with reason- 
able efficiency. In Circular No. 13 addressed to all the 
Federal Reserve agents on November 10,^ the Board 
confined its recommendations to discount operations. 
Open-market dealings were to be reserved for slow devel- 
opment, and no attempt was to be made for the time being 
to establish a unified system of clearances. 

The discount demands upon the banks immediately 
after opening were light, however, and the administra- 
tion's efforts were confined largely to developing the 
internal organizations of the banks and to the determina- 
tion of certain broader questions of policy. The most 
important of the latter was this : What should be the nor- 
mal place of the reserve banks in our financial structure?; 
Should they be continuously in the market, or should they' 
husband their resources for use primarily in emergencies? 
There were many at that time who stressed the emergency 
character of the machinery. It was the outgrowth, it was 
held, of the movement for banking reform which first 
reached greatest proportions in the framing of the Aid rich 
plan. In that project, avowedly, the new machinery in 
large degree was designed for emergency operation. 
Except on occasion of financial disturbance the National 

" Cf. Report of the Federal Reserve Board, 19 14, p. 9. 



246 FEDERAL RESERVE POLICY 

Reserve Association's activities would be limited. But in 
period of credit strain it would offer its notes to the stock- 
holding banks. 

It was also argued that the permanent functioning of 
the reserve machinery must mean undue competition 
with the member banks. It was insisted that its rediscount 
rate should normally be higher than the general money 
rate. If not, its funds would be used to the profit of the 
banks which rediscounted their paper, and the resources 
of the system, derived from the contributions of all the 
banks, would be unavailable in time of disturbance. 
Partiality in the distribution of its funds must not be 
permitted. In this vein writes C. W. Barron in his book 
on the Federal Reserve Act. He states : ' 

If the new Federal Reserve Board is of the desired quality 
and character it will be the most unpopular board that ever sat 
in Washington. It will turn deaf ears to all political and sec- 
tional considerations. The greater the clamor for cheap money 
the tighter it will hold'/the reserves within or without the coun- 
try. It will keep watchful eye upon every section to see that 
banking facilities for cornering potatoes In Maine, or cotton 
in Texas; lumber In Oregon or the Carollnas, corn In Illinois, or 
wheat in Kansas or Minnesota, are absolutely not furnished 
by any part of the reserve system over which the board presides. 

To follow out this argument, the only means of avoiding 
sectional partiality is to remain absolutely aloof from the 
money market except on occasion of great need. 

In a somewhat similar manner argued Mr. Arthur 
Reynolds, then President of the American Bankers' Asso- 
ciation, in an address delivered on June 27, 19 14. He 
regretted that every line of the Reserve Act contained an 
invitation to rediscount. He feared over-expansion of 
credit if this invitation was generally accepted.^ 

» Page 13- 

» See Commercial and Financial Chronicle, July 4, 19 14, p. 20. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 247 

A similar view was also the editorial expression of the 
Commercial and Financial Chronicle, To quote one sen- 
tence of their statement : ^ 

The point which should not escape attention is that the re- 
serves having been passed over to the keeping of the Federal 
Reserve banks, the member banks no longer have any control 
over them, and yet they are the property of the member banks 
and their character has not been changed; they are still the 
reserves of these member banks. 

Consequently they should not be dissipated except on 
occasion of intense need. 

These views, however, failed to commend themselves 
to the reserve management. Unless the reserve banks 
should get into the market, their earnings would be small. 
Earnings were held to be necessary to pay the operating 
expenses of the reserve banks, to yield a dividend on the 
stock subscriptions, to finance internal developments, and 
to maintain the prestige of the banks in the eyes of the 
public. It was argued that the resources of the reserve 
banks, if employed sparingly and wisely, need not become 
unavailable for the member banks. They could be in- 
vested mainly in such short-time liquid investments as 
could be convertible into cash without difficulty upon 
occasion of need. 

Time and experience [it was stated] will show what the 
seasonal variations in the credit demands and facilities in each 
of the Reserve Banks of the several districts will be and when 
and to what extent a Reserve Bank may, without violating its 
special function as a guardian of banking reserves, engage m 
banking and credit operations.' 

The relation between earnings and prestige was stated 

* Commercial and Financial Chronicle, January 30, 19 15, pp. 334-35. 

• Cf. Report of the Federal Reserve Board, 1914, p. 18. 



248 FEDERAL RESERVE POLICY 

as follows in one of the annual reports of the Federal 
Reserve Bank of San Francisco : ^ 

While there seems no economic defense for an effort under 
existing conditions to employ a Federal Reserve bank's funds 
for the purpose of earning profit, yet what may be called the 
psychological importance of reasonable earnings seems so great 
as to become a well-defined economic factor. . . . Earnings 
constitute the gauge of success applied by a large section of the 
public including many bankers. It is characteristically human 
to uphold the successful enterprise and to obstruct the unsuc- 
cessful. A smaller percentage of money reserve, coupled with 
unqualified approval, will constitute more potent power of 
support than larger reserves with less or popular confidence. 

It was furthermore argued that a piece of banking 
machinery unused in normal periods could not be made to 
operate with efficiency on occasions of disturbance. The 
organization would not be intact when needed. To quote 
from an address by F. A. Delano, a member of the first 
Federal Reserve Board :^ 

It might be assumed from what has been said that these 
twelve Federal Reserve banks exist solely to take care of the 
unusual, spasmodic or seasonable demands of business, or else 
those excessive demands which periodically come upon us at 
greater intervals of time. That alone might well be called a 
worthy object to attain, but it would have to be admitted that 
a ponderous and costly machine had been created to serve an 
additional demand ; and it might be doubted whether a machine 
thus kept in comparative idleness two thirds of the year would 
operate smoothly and successfully when the steam was turned 
on. 

In its Report for the year 19 14, the Federal Reserve 
Board rejected the theory that continuous operation 
would lessen the ability of the banks to meet the panic or 

' Cf . Commercial and Financial Chronicle, April 8, 1916, p. 131 1. 
» Cf. Ibid., February 27, 1915, p. 697. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 249 

emergency needs of their members/ What was required 
was such a control of credit, in times of business optimism 
as well as of depression, that serious difficulties would 
never arise. In periods of excessive activity, the banks 
should exercise a restraining influence by withdrawing 
support from the markets. In periods following extensive 
liquidation, they should offer their funds freely. 

Normally, therefore, a considerable proportion of its resources 
should always be kept invested by a Reserve Bank in order 
that the release or withdrawal from active employment of its 
banking funds may always exercise a beneficial influence. 

But no matter what decision should be reached on 
grounds of business expediency, the reserve administra- 
tion held the terms of the statute were such as clearly to 
indicate the desire of the lawmakers that operation should 
be continuous. Aside from any duty of earning dividends 
for shareholders, section 14 of the act stated that the rates 
of discount ** shall be fixed with a view of accommodating 
commerce and industry." For occasions on which there 
was no demand for discounts, reserve banks were endowed 
with open-market powers. It seems to the writer that 
throughout the Reserve Act there is indicated the inten- 
tion of the lawmakers that reserve banks should do some- 
thing more than merely to offer emergency relief. The 
reserve system was intended to operate continuously. 

But the problem of getting into the market was one of 
great difficulty. Because of the reduction in reserve re- 
quirements, member banks could expand their loans con- 
siderably without engaging in any large amount of redis- 
counting. In the early part of 19 15 the export trade was 
heavy and gold imports on an enormous scale began. The 
member banks were in so strong a reserve position that, 

* See pp. 17-19 



250 FEDERAL RESERVE POLICY 

despite the very moderate rates demanded by the reserve 
banks, there was no large demand for rediscounts. In this 
situation, accordingly, the reserve banks were forced to 
turn to their open-market powers in order to find effective 
use for their funds. Dealings in Government bonds and 
municipal warrants were especially large in 19 15. 

But there were limits to the extent to which open- 
market purchases could be made with expediency. The 
reserve system was in its infancy, and it was particularly 
necessary that it avoid creating the appearance of being a 
competitor of member banks. The problems^of attracting 
a larger membership from State institutions and of secur- 
ing the allegiance of all classes of banks to the voluntary 
clearance plans had still to be worked out. Despite the 
fact that the volume of operations at first was'not much 
more than sufficient to meet the expenses of operations, 
there was a general disposition on the part of member 
banks to view the reserve banks as rivals and not as ser- 
vants. Now and then the argument was advanced that 
the capital stock subscriptions of member banks should be 
returned. As typical of such views the following utter- 
ances may be quoted from an address delivered in August, 
19 1 5, by Frank C. Mortimer, Cashier of the First National 
Bank of Berkeley, California : * 

The present law appears to place the Federal Reserve banks 
in competition with member banks through open market opera.- 
tions. This has already been availed of by the purchase of war- 
rants and other instruments of credit. The abnormally heavy 
reserves now carried by national banks might have been profit- 
ably employed by them, at fair rates of interest, through the 
purchase of the very obligations now held by the Federal 
Reserve banks. 

The open market operations of the Federal banks are 
expected, in a measure, to regulate interest rates throughout 

* Cf. Commercial and Financial Chronicle^ September 18, 1915, p. 888. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 251 

the country and should be exercised in the manner indicated. 
Since their organization there has been no complaint regarding 
abnormally high interest charges. Therefore, there appears to 
be no valid reason for any open market operations at this time. 

In buying in the open market the Reserve banks already 
have been in competition with member banks, and they appear 
to have demonstrated that they are operating, not altogether 
as emergency banks, to be used during periods of financial 
stress but as open competitors of member banks. 

The question naturally arises: At times, when there is no 
demand for the rediscounting privilege, are the Federal Reserve 
banks forced to compete with member banks by going into the 
open market and buying municipal and other warrants, in order 
that they may earn expenses and pay the expected dividend of 6 
per cent. 

If this is the situation, there exists a very good reason for the 
return of the capitalization to the member banks and the elimi- 
nation of the implied obligations on the part of the Reserve 
banks of earning a dividend of 6 per cent. 

The return of the capital stock of Federal Reserve banks to 
member banks has more than incidental bearing on the success 
of the whole system. With the elimination of this feature, 
which never has set well upon the national banks, the State 
banks, recognizing the value of the rediscount feature, in all 
probability would voluntarily and quickly apply for membership. 

The desirability of returning the paid-in capital of the 
reserve banks will depend upon the reader's conception of 
the nature of the reserve system. If he believes it desirable 
that the reserve banks should attempt to exercise any 
large measure of continuous control over the money 
market, then he would oppose the proposal. Not until the 
influence of the reserve bank system was more firmly 
established would it appear feasible to lessen its resources. 
If, on the other hand, the reserve system is to operate in a 
purely palliative manner, if it was intended to confine its 
services primarily to occasions of financial disturbance, 
greater objection would be made to the capital stock 



252 FEDERAL RESERVE POLICY 

feature. For such a system the apparent necessity of 
earning dividends must prove a frequent source of embar- 
rassment. It might compel the abandonment or modifi- 
cation of policies formulated solely in the interest of finan- 
cial necessities. But the whole question throws into strik- 
ing relief the difficulties confronting the management at 
the beginning of this period. The reserve system must get 
into the market in order to fulfill its purpose. But the 
task of getting into the market rendered inevitable many 
serious problems of financial readjustment. To employ 
Delano's figure of speech : ' 

It was like the problem of reconstructing a great office 
building, changing an antiquated construction and substituting 
therefor steel and marble, yet accomplishing it. all without 
serious inconvenience to the tenants. 

^ As regards the rate policy of the Board it has been re- 
marked previously that it was believed desirable to act 
with prudence and conservatism at first. Accordingly, in 
the first schedule, rates were fixed at from 5>^ to 6^ per 
cent. But as in the case of qualifications for eligibility,* 
it was soon perceived that these requirements were too 
high. Accordingly, upon the applications of the various 
reserve banks the rates were lowered from time to time. 
On December 30, 19 14, the rate on 30-day paper was 4K 
per cent in four districts and 5 per cent in all the others.^ 
Paper of longer maturity commanded slightly higher 
rates. On this date the differentials were based entirely 
on maturities. 

In 191 5 further reductions were made. At the close of 
the year the rate on bankers' acceptances was 2 to 4 per 

' See Bulletin, October i, 1915, p. 298. 

"See supra, Chapter IV, pp. 82-83. 

3 See Report of the Federal Reserve Board, 1914, Exhibit M, p. 203. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 253 

cent, the lowest figure usually prevailing; and 90-day 
trade acceptances were discountable in most districts at 
3>2 per cent. The 30-day commercial paper rate was 4 
per cent in all districts, save the San Francisco district, 
where the rate was 3>^ per cent.' 

Save for a slight tendency toward stiffening at the close 
of the year, these rates were not altered greatly during 
1916." 

In order to indicate the general discount situation 
during these years, the table on page 254 (Table No. i) is 
presented. The figures show that the total volume of 
discounts (column 5) increased considerably in 191 6 over 
1915; 1916 also showed a marked shifting in the maturities 
of the paper. In 191 5 paper maturing in less than 30 days 
was exceeded both by the 30-60-day paper and the 60-90- 
day paper. In 1916, however, paper of the shorter matur- 
ity exceeded all other classes combined. In fact, for the 
month of December, 1916, discounts of paper maturing 
within 30 days was considerably larger than the year's 
total for any of the other classes. This may be interpreted 
possibly as evidence of the increasing strain upon the 
money market toward the close of the year. Rediscount- 
ing was becoming more general and member banks were 
offering a more representative lot of paper on their redis- 
count applications. 

As to the district origin of the paper Table No. 2 on 
page 254 gives information. In 191 5 there was little de- 
mand for rediscounts save in the three Southern districts 
of Richmond, Atlanta, and Dallas. But in 191 6 the re- 
discounts in the Boston, New York, Philadelphia, and 
Chicago districts compared favorably with those in the 
three Southern districts. 

^ See Report of the Federal Reserve Board, 1915, Exhibit A, p. 27. 
» Cf. Ibid., 1916, Exhibit A, pp. 35-39. 



254 



FEDERAL RESERVE POLICY 



Table No. i 
Volume of Discoxjnts for Entire System by Types of Paper » 

Classification 



Date 



Maturing 
Within 
30 Days 



30 Days to 
60 Days 



60 Days to 
90 Days 



Ag. Paper 

Maturing 

After 90 Days 



Total Com- 
mercial Paper 
Discounted 



In Thousands of Dollars 



1914 












November 


$ 7.306.2 


$ 1.929.1 


$ 585.6 


$ 128.2 


$ 9,949.1 


December 


5.074.5 


3,250.9 


2.620 9 


515.6 


11.461.9 


1915 

January 


4,109.3 


3,627.0 


2.365.1 


611.4 


10.712.8 


February 


2.957.5 


5.421.7 


3.265.9 


885.2 


12,530.3 


March 


1.798.6 


5,257.4 


5.162.9 


1,180.8 


13,399.7 


April 


1.239.0 


3,500.9 


4,166.4 


1,643.0 


10,549.3 


May 


1.631.5 


3,800.8 


4,331.1 


2,382.3 


12,145.7 


June 


1.810.3 


3.905.3 


5.187.2 


2,503.2 


13,406.0 


July 


1.715.9 


4.512.4 


5.294.3 


1,715.4 


13,238.0 


August 


1.700.3 


4,990.9 


4.520.1 


1,022.4 


12,233.7 


September 


1,829.9 


6,180.0 


5.306.5 


1.088.6 


14,405.0 


October 


2.160.4 


5,327.4 


5.671.0 


1,892.0 


15,050.8 


November 


2,730.8 


6.242.0 


6.791.2 


2.505.7 


18,269.7 


December 


2,825.7 


5,0U..6 


5,260.7 


2.254.0 


15,412.0 


Total. 1915 


S 26.509.2 


$57,837.4 


$57,322.4 


$19,684.0 


$161,353.0 


1916 
January 


$ 2,118.8 


$ 3,359.2 


$ 4.121.6 


$ 1.515.4 


$ 11,115.0 


February 


1.104.3 


2,558.4 


2,995.8 


1,006.1 


7,664.6 


March 


1,202.1 


3,176.7 


3,805.5 


1,203.0 


9,387.3 


April 


4,363.9 


2,373.2 


3,017.1 


1,767.3 


11,521.5 


May 


3,220.0 


2,623.3 


2.961.3 


2,390.9 


11.195.5 


June 


3,271.6 


2,377.6 


3.084.4 


2,926.4 


11,660.0 


July 


10,645.0 


2,747.5 


4.965.8 


1,824.7 


20,183.0 


August 


8,339.6 


3,447.3 


4,521.7 


1.043.2 


17,351.8 


September 


5.342.6 


3.898.4 


4,107.4 


960.4 


14,308.8 


October 


4.392.7 


3,492.6 


3.126.4 


851.5 


11,862.9 


November 


13.497.3 


1,626.1 


1,895.9 


884.8 


17.904.1 


December 


57.555.5 
$115,053.1 


2.742.6 
$34,422.9 


2,973.7 
$41,576.6 


442.2 


63,716.0 


Total. 1916 


$16,825.9 


$207,870.5 



Figures taken from A nnual Reports of the Federal Reserve Board, 

Table No. 2 
Distribution of Discounts by Districts 





In Thousands of Dollars 


District 


Nov. 16, 1914-Dec. 31, 1915 


Jan. 1, 1916-Dec. 31, 1916 






Per Cent 








Amount 


in 1915 


Amount 


Per Cent 


Boston 


$ 2,386.9 


1-3 


$33,921.9 


16.3 


New York 


9,668.7 


3-0 


22,329.5 


10.7 


Philadelphia . 


6,839.7 


3-2 


22,328.4 


10.7 


Cleveland 


5,201.3 


2.8 


6,792.4 


3-3 


Richmond . . . 


47,076.1 


27.8 


34.377.2 


16.5 


Atlanta 


35,336.6 


21.2 


22,323.2 


10.7 


Chicago 


14,648.5 


5.7 


23,178.1 


1 1.2 


St. Louis 


8,231.2 


3-9 


8,842.7 


4.3 


Minneapolis. . 


5,870.3 


3.2 


6,473.5 


^.i 


Kansas City.. 


11,385.3 


6.8 


6,817.7 


3.3 


Dallas 


27,795.8 


16.6 


18,512.5 


8.9 


San Francisco 


8,326.6 


4-5 


1,973.4 


I.O 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 255 

During these years discounting for banks in the Nation's 
financial center, New York City, was conspicuous because 
of its almost total absence. The exceptional nature of 
rediscounts for the metropolitan institutions is indicated 
by the following statement issued by the New York Fed- 
eral Reserve Bank early in December, 1916:^ 

During the course of the day a number of New York City 
banks, including among others . . . made use of the rediscount 
facilities of the Federal Reserve Bank of New York. While the 
amounts of the rediscounts were not large, the facility and 
promptness with which the credits were obtained serves to illus- 
trate in a practical way, for the first time in the history of the 
bank, the readiness of the Federal Reserve system to meet the 
calls made upon it. The officers of the Reserve Bank expressed 
themselves as much gratified with the attitude of the member 
banks in making use of their facilities, it being apparent that 
the rediscounting had been undertaken not so much because 
there was any necessity for it, but rather to inaugurate the prac- 
tice which, while already a commonplace at other Federal 
Reserve banks, had not heretofore become an established pro- 
cedure in New York. 

The number of member banks accommodated through 
the discount of commercial paper was somewhat similar 
in the two years. In 191 6, 23.4 per cent of all member 
banks received discount credits from reserve banks. The 
figures for 1914, 1915, and 1916 were as in Table No. 3 
on page 256. 

According to the figures of Table No. 4 on page 256, 
the amount of paper most commonly discounted during 
19 1 6 was ?iooo to ^2500. But approximately an equiva- 
lent amount of pieces in size from ^250 to ?500 and ^500 
to ?iooo were discounted. More pieces of paper under ?ioo 
were discounted than from ^5000 to ;Jio,ooo. These facts 

' Cf. Commercial and Financial Chronicle^ December 9, 1916, p. 21 18. 



256 



FEDERAL RESERVE POLICY 



Table No. 3 
Number of Member Banks Accommodated Through Discount 

OF Commercial Paper 



District 


Nov. 16, 1914-Dec. 31, 1915 


1915 


1916 


Boston 


29 

54 
70 
88 
226 
248 
221 
131 
197 
274 
366 
169 


19 

49 

65 

81 

226 

247 

143 
129 
176 
258 
360 
167 

1,920 


56 
62 


New York 


Philadelphia 


143 

50 

202 


Qeveland 


Richmond 


Atlanta 


209 
212 


Chicago 


St. Louis 


114 
174 

189 

301 

76 


Minneapolis 


Kansas City 


Dallas 


San Francisco 


Total 


2,073 


1,788 







Table No. 4 
Commercial Paper Discounted by Size for the Year 191 6 » 



Size 


Number of Pieces 


Amount in Thousands 
OF Dollars 


To $100 


4.407 
12,088 

14.551 

14,907 

15,460 

9,608 

3.391 

1,871 

76,283 


$ 322.6 

2,137.4 
5.670.8 

II.391.5 
26,120.4 
38.756.2 
26,750.9 
96,720.7 
207,870.5 


$100-2^0 


2^0-SOO 


500-1000 


1000-2500 


2500-5000 


5000—10,000. 


Over $10,000 


Total 





» See Report of the Federal Reserve Board, 1916, p. 91. 

tend to combat the assertion that the principal advantages 
of the reserve system would enure to the large borrower. 

Table No. 5 on page 257 gives certain information 
regarding the amount of the open-market purchases dur- 
ing 19 1 5 and 19 16. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 257 

Table No. 5 

Total Investment Operations (Purchased Paper and Discounted 

Paper) 

In Thousands of Dollars 



Date 


Commercial 

Paper 
Discounted 


Purchased i 

Acceptances 

Bankers' and 

Trade 


United States 

Bonds 

Purchased 


Municipal 
Warrants 
Purchased 


1914 
November . . 
December.. . 

1915 

January 

February . . . 

March 

April 

May 

June 

July 

August 

September . . 
October .... 
November . . 
December. . . 


$ 9,949.1 
11,461.9 

10,712.8 
12,530.3 
13.399-7 
10,549-3 
12,1457 
13,406.0 
13,238.0 
12,233.7 
14,405.0 
15,050.8 
18,269.7 
15,412.0 


$ 2,666 
8,356 
4,018 
2,865 
4,701 
5,986 
4,656 
4,548 
6,340 
7,919 
12,790 


$ 205 

2,650 

2,566 

1,340 

75 

285 

559 

477 

735 

488 

1,200 

2,988 

2,347 


$ 677 

10,087 
2,583 
3,739 
3,196 
4,946 
4,512 
7,346 

11,750 
4,115 
1,370 
9,001 
3,210 


Total 1915 

1916 
January .... 
February . . . 

March 

April 

May 

June 

July 

August 

September . . 
October .... 
November . . 
December . . . 


$161,353.0 

$ 11,115 

7,664 

9,387 

11,521 

11,195 
11,660 
20,183 

17,351 
14,308 
11,862 

17,904 
63,716 


$64,845 

$ 9,602 
12,416 
22,918 
18,499 
21,911 
42,325 
36,575 
28,446 
37,086 
40,894 
48,547 
66,871 


$15,918 

$ 6,627 
9,496 
8,249 

10,479 
6,113 
1,322 

341 
501 

2,193 
257 

5,628 

5,539 


$65,859 

$9,806 
10,450 

10,425 
10,361 

8,979 
5,477 
7,254 
1,602 
5,090 
10,267 
7,565 
3,404 


Total 1916 . 


$207,870 


$386,095 


$56,750 


$90,686 



First purchase of acceptances, February 19, 1915. 



By means of these operations the reserve banks were 
able to make a fair showing regarding earnings in 19 15 



258 FEDERAL RESERVE POLICY 

and 19 1 6. In these two years all earned expenses and were 
able to contribute a small amount to dividends. From the 
Report of the Federal Reserve Board for the year 19 16 we 
read : ^ 

The figures for the whole system to December 31, 1916, 
show an average net earning since organization of 3 per cent on 
the actual paid-up capital, while for the year 1916 they show 
an average net earning of 5 per cent. 

In comparing reserve banks' operations with those of 
private institutions, it must be remembered, however, 
that a portion of their capital is obtained without the 
issuance of stock. The law required member banks to 
deposit a portion of their reserves with the reserve banks. 

Because of the rather limited scale of its operations, the 
reserve system approached the close of this period with 
exceedingly high reserves. December 30, 19 16, the ratio 
of the gold reserves of the reserve banks to the net deposit 
and Federal Reserve note liabilities was 79.4 per cent. 
On this date the cash reserve ratio was 81.4 per cent. 

Despite the limited demands upon its resources, it 
appears undeniable to the writer that in this period the 
reserve management should be credited with a remarkable 
achievement. The legitimate needs of business were met 
without the sacrifice of principle on the one hand or the 
establishment of unduly bureaucratic methods upon the 
other. The requirements for eligibility of paper presented 
for rediscount were fair. The practice of discounting had 
become sufficiently prevalent to point the way to member 
banks for the solution of their future emergency require- 
ments. Analysis of the number of banks served, of the 
size of the paper discounted, of the districts of origin, gave 
results which could not be employed to justify charges of 
favoritism. The reserve management had convinced the 
« Page 13. 



DEVELOPMENT, NOV., 1914, TO DEC, 1916 259 

member banks that its services were at the disposal of all 
banks and all districts. 

While progress in popularizing the trade acceptance 
was slow, it had proceeded upon a sound basis. The firms 
won over to its use were in large measure those of high 
credit rating. Progress in the popularization of the bank- 
ers' acceptance was favorable. 

In check collections the reserve system had proceeded 
slowly but cautiously. But by the middle of 19 16 the 
foundations had been laid for a country-wide par clearance 
scheme which was finally to include the greater part of the 
country's banks, non-member as well as member. These 
steps had to be taken in the face of much legislative and 
political objection engendered by the large number of 
exchange-charging banks. 

By amendments to the act and various administrative 
measures, much progress had been made in the movement 
to conserve the Nation's gold supply. On December 29, 
1916, its total gold reserve was 2453,000,000. On the same 
date a total of ^282,000,000 was deposited with the re- 
serve agents as cover for the Federal Reserve note issues. 
The reserve banks were accumulating gradually a larger 
and larger portion of the country's gold. This concentra- 
tion of gold increased the reserve system's power for evil 
as well as for good. But it would not have been courageous 
to have declined to accept this opportunity. 

No occasions for inter-district rediscounting occurred 
in this period. But knowledge of the possibilities of secur- 
ing extra-district aid enabled industry to count upon 
the support of its banks with greater certainty. 

In the Gold Settlement Fund at W^ashington the begin- 
nings had been laid for a machinery which finally was to 
enable domestic transfers of currency to be made with a 
minimum of cost and physical effort. 



26o FEDERAL RESERVE POLICY 

The principal disappointment had to do with the refusal 
of the great majority of State banks to enter the system. 
But it seems clear that only by undesirable concessions 
could the system have been made such as to attract the 
voluntary entrance of many. 

Lastly, the internal organization had been developed 
to meet the requirements of the future. The preliminary 
work had been accomplished. This period was one of 
achievement. But primarily the achievements were those 
of preparation. 



CHAPTER XIII 

FEDERAL RESERVE DEVELOPMENT, JANUARY, 1917 
TO APRIL, 1917 

In the early period of reserve operation the demand for 
rediscounts was light and the reserve banks were able to 
exercise little control over the money market. Toward the 
close of 1916, however, the general boom in industry had 
begun to throw some strain upon the credit mechanism. 
As a consequence several reserve banks in December, 1916, 
increased their rates slightly and for the first period of 
their existence the member banks became somewhat sensi- 
tive to their rediscount policy. As stated by Governor 
Harding in the January, 19 19, Bulletin: 

the only period when the Federal Reserve Board was able to 
exercise any effective control over the banking situation was 
during the last two or three months of 19 16 and the first quarter 
of 1917.' 

It might be expected, accordingly, that 191 6 would 
mark the close of the period of experiment and prepara- 
tion, and that permanent principles governing rediscount 
and open-market operations would soon crystallize. Prior 
to 19 17 there was no danger of credit and currency infla- 
tion. The inflow of gold from Europe and the reduction 
of reserve requirements by the terms of the act left mem- 
ber banks in an exceedingly strong reserve position. Under 
this situation member banks could provide credits without 
great deference to the policy of the reserve administra- 
tion. There was then little objection to be made to the low 

» Page 2. 



262 FEDERAL RESERVE POLICY 

rates. Rather they appeared to be an outright advantage. 
In the first place, these low rates tended to encourage 
member banks to make rediscount applications and thus 
emphasized the helpful possibilities of the system. Sec- 
ondly, they served to indicate the fundamental soundness 
of America's financial condition. 

No system of central banking, however, can continue 
forever to serve as an agency for credit expansion, and it 
might be expected, accordingly, that in 19 17 a beginning 
would be made in establishing a permanent basis for 
advances to member banks. The principle accepted might 
be to keep the reserve banks' rates above those of the 
general market or to base the volume of rediscounts upon 
the productive requirements of the community where the 
applications arose. But no matter what the basis of pro- 
cedure, it was clear to ail thinkers that in the first two 
years of operation no real progress had been made in this 
direction. Financial conditions in these years were such 
as to make unnecessary the solution of this problem. 

As political events shaped themselves, however, neither 
1917 nor any subsequent year was to be such as to permit 
idealistic consideration of the proper basis for rediscount 
operations. Very early in 19 17 it became clear that only 
by receding from our oft-stated position regarding the 
rights of neutrals armed clash with Germany could be 
avoided. Prospects of entering the conflict overshadowed 
all other considerations, and the task of the reserve admin- 
istration was to place the reserve banks in shape to meet 
the financial strain of war. It was understood that the 
Treasury's plan would involve huge borrowing operations 
and that these could be rendered successful only by the 
active cooperation of the banks. Credits would be re- 
quired, not merely to finance our own expenditures, but 
also those of our allies whose purchase of war supplies in 



DEVELOPMENT, JAN., 1917. TO APRIL, 1917 263 

this country would increase as a result of our declaration 
of war. A credit system, moreover, not efficiently ordered 
before war, could scarcely be expected to be prepared 
during hostilities for the requirements of post-war recon- 
struction. The problem then would exist of transferring 
labor and capital from the production of war supplies to 
the industries of peace. 

It was during this period, accordingly, that much of the 
work of concentrating the control of the country's gold 
was accomplished. In January the Board proposed the 
amendments which became law June 21, 19 17, and which 
required member banks to maintain their entire legal 
reserves with reserve banks. The Board also suggested 
that it be given power to raise the reserve requirements of 
member banks in emergencies. Congress refused, however, 
to accept this amendment. At the same time proposals 
were made to render membership more attractive to State 
banks and trust companies and preparations were made 
for ensuring an adequate supply of Federal Reserve notes. 

During the months of January and February it placed addi- 
tional orders with the Bureau of Engraving and Printing, 
through the Comptroller of the Currency, for more than 
$900,000,000 of notes, and arranged also that the stock of notes 
on hand should no longer be reduced through withdrawals for 
current needs, but that as drawn upon by the Federal Re- 
serve Banks new orders in equal amount should be placed 
automatically.^ 

In view of the anticipated future strain it might have 
been expected that discount rates would have been in- 
creased during this period. The state of the money 
market, however, was such as to necessitate compara- 
tively few alterations. For instance, the rates on commer- 
cial paper maturing within 61 to 90 days were increased 

* Report of the Federal Reserve Board, 19 17, p. 2. 



264 FEDERAL RESERVE POLICY 

in this period in only two districts. In January, the 
Atlanta and Dallas banks increased their charges one half 
of one per cent. 

With these rates the discounts for member banks of 
the first quarter of the year totaled ^67,523.7 thousand. 
This compares with totals of ?28, 166.9 thousand and 
?36,642.8 thousand in the corresponding periods of 1916 
and 19 1 5. The dependence of member banks upon re- 
discounting was increasing somewhat. 

It might be surmised that this increased rediscounting 
must have been at the expense of the reserve banks' legal 
reserves. It is true that the reserve accounts of members 
on the books of reserve banks increased somewhat. On 
January 26, members' reserve accounts were ?687,84i,ooo. 
On February 23, they were ^692,475,000 and on March 30, 
2720,411,000. The circulation of Federal Reserve notes, 
on January 26, was ^259,768,000; on February 23, 
?303»i7i»ooo; and, on March 30, ^357, 610,000. But as a 
result of the continuous impounding of gold the total cash 
reserves advanced steadily from ^758, 242,000 on January 
5 to ^962, 662,000 on April 6.' Consequently, the ratio of 
cash reserves to aggregate net deposits and Federal Re- 
serve note liabilities remained continuously above 82 
per cent. On April 6, the date of the declaration of war, 
it was 84 per cent. 

The enlarging gold holdings of the reserve banks made 
possible also an increase in the open-market investment 
operations without lowering the reserve ratio. This is 
indicated by the table on page 265.^ 

On January 5, 1917,^ the gold of the reserve banks 
in excess of required reserves — free gold, in other 

' Report of the Federal Reserve Board, 1917, p. 64. 
» lUd., p. 131. 
3 Ihid., p. 70. 



DEVELOPMENT, JAN., 1917, TO APRIL, 1917 265 



Year 


Amount Purchased in 


January 


February 


March 


I917 

1916 

I915 


$49,105,356 
37,150,980 
23,450,300 


$99,502,895 
40,028,950 
20,345,800 


$66,495,153 
50,981,150 
26,834,900 



words — amounted to ^42 1,155,000. On April 6 it had 
increased to ^545,959,000. On the basis of this free gold 
an enormous expansion of credit advances to member 
banks or of Federal Reserve note issues was possible. 
This free gold would provide a 40 per cent reserve for a 
deposit or note expansion of ? 1,164,697,500. This would 
exceed the sum of the outstanding Federal Reserve note 
circulation and book credit advances to member banks 
(?i, 134,729,000) by ^29,978,500. And the process of 
attracting gold into the reserve reservoir had yet to attain 
full proportion. Few State banks had joined the system, 
and the amendment of June 21, 1917, requiring member 
banks' legal reserves to be kept in their entirety in reserve 
banks, had not yet been enacted. 

In view of the fact that this period closes before the 
amendment of June 21, 19 17, and in view of the further 
fact that the reserve banks' reserves were to be enlarged 
by successive accretions of gold, it would be unprofitable 
to calculate the amount of credit and note-issue expansion 
which the reserve banks' reserves would support on the 
date of the outbreak of the war. But a few facts relating 
to the conditions of member banks will serve to enable us 
better to understand the credit situation at this time. 

March 5, 19 17, the required reserve for the net deposits 
of member banks was not quite 15.5 hundred millions of 
dollars. On this date the actual reserve (vault reserve, 
plus amount due from Federal Reserve banks plus amount 
due from reserve agents) was almost 26.5 hundred 



266 FEDERAL RESERVE POLICY 

millions.^ Irrespective of any further aid to be secured 
through rediscounts, the member banks, as a whole, were 
in an exceedingly strong reserve position. 

These facts should not be interpreted, however, as pro- 
viding solely a basis for congratulation. It is true that 
the public and the banks were destined to support a war 
finance programme of unparalleled magnitude. It is also 
undebatable that without the Federal Reserve all this 
would have been impossible. But it is still true that the 
huge surplus reserves gave a false sense of security. They 
seemed to justify expenditures by the Government of any 
amount for any purpose. Much delay and many mishaps 
were to be encountered before it came to be realized that 
the problem of war finance was not primarily one of sup- 
plying dollars, but rather one of securing for war purposes 
labor and materials. Some time was to elapse before it 
could be understood generally that labor and materials 
were limited in supply even if dollars were not. 
' Cf. Bulletin, June i, 19 17, p. 484. 



CHAPTER XIV 

FEDERAL RESERVE DEVELOPMENT, MAY, 191 7, 
TO NOVEMBER 11, 1918 

The general policy of the Federal Reserve administration 
during the period of our participation in the World War 
may be epitomized briefly as one of complete and cordial 
cooperation with the Treasury. Once the Treasury had 
announced its plans, the banking machinery was adapted, 
so far as possible, to the work of furnishing the necessary 
financial support. To quote from the Bulletin for January 
I, 1918:' 

Under the leadership of the Secretary of the Treasury ^ the banks 
have done their duty admirably in placing both the short- and 
long-term securities of the Government. 

The financial story of the war can thus be read to a very 
large extent in the policies of the Federal Reserve Board. 

The first respect in which the reserve banks were called 
upon to lend their facilities to the Treasury was in con- 
nection with the sale of short-term Treasury certificates. 
Only to a limited extent were funds for war purposes 
obtained in advance of disbursements by means of taxa- 
tion or bond sales. In large measure funds would be 
acquired first through the sales of short-term certificates. 
Upon their due dates the accumulated certificates would 
be retired through the proceeds of taxation and bond sales. 

The Treasury announced at an early date its intention 
to follow this policy. On April 20, 19 17, Secretary McAdoo 

'Page I. 

■ Italics are the writer's. 



268 FEDERAL RESERVE POLICY 

stated that as soon as the War Loan Bill became law sev- 
eral hundred million three per cent certificates, payable 
June 30, would be issued.^ In order to avoid temporary- 
shortage of banking funds in the communities where the 
certificates were purchased, the Treasury stated that 
disbursements would be made in such a way "that as far 
as possible money paid in will be promptly returned to the 
market." ^ But in case these measures should prove in- 
sufficient, it was announced by Governor Harding that * 
"the Federal Reserve Banks may be counted upon by 
offering liberal terms of rediscounting to do their utmost 
in counteracting any effect of temporary dislocation of 
banking funds." Within a month there were three issues 
of these certificates totaling ^650,000,000. 

But what specific measures should be provided to 
render efifective this offer of support to member banks? 
It was evident that no alterations need be made in the laws 
or regulations governing eligible paper. The original act 
permitted the reserve banks to rediscount customers' 
paper drawn for the purpose of carrying bonds of the 
Government of the United States. Since the amendment 
of September 7, 19 16, provision had existed for the direct 
discount of member banks' promissory notes secured by 
"pledge of bonds or notes of the United States" as well as 
by eligible paper. Federal Reserve support was in large 
measure, therefore, a question of the rates of discount. 

In the Bulletin of June i, 19 17, we read: ^ 

The Board, therefore, recently took under consideration the 
question of establishing a rate of discount for the short-term 
notes of member banks secured by Liberty bonds or by short- 
term certificates as collateral, as well as the question of a favor- 

^ Bulletin, May i, 1917, pp. 341-42 

i Ibid., p. 2^. 
-• Page 425. 



DEVELOPMENT, MAY, 1917. TO NOV. 11, 1918 269 

able rate of rediscount for customers* notes collateraled by such 
bonds or certificates and offered by the member banks to the 
reserve banks with their own endorsement. 

As a result of this consideration the Board announced in 
May its willingness to approve a rate of 3 per cent on 
member banks' notes collateraled by war paper. On May 
22, it issued a circular stating that it would ratify a rate 
of 3>^ per cent on the rediscount of customers' notes 
maturing within ninety days secured by Government 
bonds or Treasury certificates. Since the first war bonds 
bore interest at 3>^ per cent, the bond subscriber was 
id.irly well protected against the dangers of subscriptions 
exceeding his ability to pay. 

Inasmuch as the rate of interest increased on later issues 
of war bonds, it would be expected that the reserve banks' 
rates would increase also. Accordingly on the date of the 
armistice the rate was ^}i per cent on 16-90-day paper 
secured by war issues. In addition to these measures 
some use was made of a 3-4>^ per cent rate on one-day 
discounts arising in connection with the Government's 
loan operations. 

It did not seem feasible to the reserve management to 
establish high rates on other types of paper even in this 
period of capital-strain. All rates of interest are more or 
less closely related. High money charges exacted from the 
public on business loans would increase the difficulty of 
selling war bonds at low rates. Accordingly the 90-day 
rate on commercial paper, which on April 30, 1917, was 
4 per cent in five districts, and ^}4 per cent in seven, was 
advanced only slightly during the period of hostilities. 
On the date of the armistice it was 4^ per cent in seven 
districts and 5 per cent in the others. 

But the reserve . banks did not confine their efforts to 
keeping their own rates low. In many ways they endeav- 



270 FEDERAL RESERVE POLICY 

ored to bring pressure on member banks to offer loans to 
the public cheaply, as well as to maintain low rates on 
deposits. For instance, in the schedule of rates for Octo- 
ber 31, 19 18, the member banks' ability to secure a 4 
rather than a 4^ per cent rate would depend, in two 
districts, upon whether the customer's paper had been 
discounted at a rate not exceeding that borne by the 
bonds. On several occasions we find the reserve admin- 
istration cautioning banks against raising rates allowed on 
deposits. To quote from a letter by Governor Harding of 
February 26, 1918:^ 

Banks should remember that when deposits are reduced 
reserves are released. Reckless competition for deposits sup- 
ported by high interest rates will tend to force the Government 
to pay higher rates, thereby imposing additional burdens on the 
people; and any forced and artificial expansion of banking 
credits will promote rather than check inflationary tendencies, 
which should be guarded against at the present time. There 
does not seem to be any demand on the part of depositors for 
increased rates of interest on their balances, and the Board 
wishes it understood that it does not favor any movement to 
increase these rates and that it will do all in its power to dis- 
courage it. 

Because of the enormous demand upon the reserve 
banks* rediscounting facilities during the war, mere sug- 
gestions from the Board were undoubtedly more than 
ordinarily efficacious. But enough has been stated to indi- 
cate the complete cooperation of the reserve banks with 
the Treasury. The writer has found no important instance 
in which there was displayed an unwillingness to refuse 
support for the Treasury's low interest policy in the sale 
of war bonds. 

In the preceding chapter^ some information has been 

' See Bulletin, April i, 19 18, p. 252. 
» See supra, pp. 264, 265. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 271 

given regarding the ability of the reserve and member 
banks to meet the demands upon them. There it was 
shown that, at the outbreak of hostilities, the member 
banks' surplus reserves were huge and that the free gold 
of the reserve banks would permit more than a doubling 
of the issues of Federal Reserve notes and of credit 
advances to member banks. But the expansive possi- 
bilities of the system should be calculated on a date sub- 
sequent to the amendment of June 21, 1917, which lowered 
reserve requirements and provided for their transfer in 
entirety to reserve banks. Since the Comptroller's figures 
bearing upon the condition of national banks may be had 
for November 20, 19 17, the writer has selected November 
23 as the date for his calculations as to the amount of 
bank credits the surplus reserves of reserve banks might 
enable member banks to grant the public. All figures are 
given in thousands — i. e., 000 omitted. ^ 

1. Gold reserve for federal reserve notes. 

On November 23, 19 17, the gold reserve for note Issues 
totaled $635497 ($623,948 deposited with the reserve agents 
plus $11,549 in the gold redemption fund). 

On this date the notes in actual circulation totaled $1,051,892. 

The actual gold reserve was T, or 62.5 per cent. The 

^ 1,015,892 ^ ^ 

minimum 40 per cent required would be $406,356. 

The excess reserve for notes was $635,497 less $406,356 or 

$229,140. 

2. Possibilities of further note expansion. 

Supposing the excess reserve for notes to be used to support 
the maximum value of notes, a further note issue is possible of 
2>^ times $229,140 or $572,850. 

3. Reserve for member bank deposits.' 

* This calculation is quoted from H. L. Reed, "Credit Expansion under the 
Federal Reserve," American Economic Review, June, 1918, pp. 270-82. See 
pp. 279, 280. 



272 FEDERAL RESERVE POLICY 

On November 23, 19 17, the net deposits of all the reserve 
banks totaled $1,546,122; computed as follows: 

Government deposits $ 196,411 

Due to members (reserve account) 1,426,648 

Due to non-members (clearing account). ... 22,291 
Collection items 215,169 

Total gross deposits $1,860,519 

Due from other reserve banks, net $ 11,872 

Uncollected items 302,525 

Total deductions 314.397 

Net deposits $1,546,122 

The gold reserve for net deposits totaled $969,207, as follows: 

Gold coin and certificates in vault $530,045 

Gold settlement fund 385,662 

Gold with foreign agencies 52,500 

Total $969,207 

The gold reserve for deposits was — ^-^ — - or 62.6 per cent. 

1,546,122 

The total lawful money reserve for depos- 
its (gold reserve plus legal tender notes, 
silver, etc.) was $969,207 plus $54,058 
or $1,023,265 

The lawful money reserve required (35 

per cent minimum) would be 541,142 

The surplus reserve for deposits was $ 482,123 

4. Possibilities of further expansion of deposit credits of re- 
serve banks. 

« Supposing the'surplus reserve for deposits to be used to sup- 
port the maximum volume of member bank deposits, an increase 

100 
in these is possible of times $482,123 or $1,377,494. This 

35 
represents a potential increase of more than 95 per cent. (Mem- 
ber bank deposits with reserve banks on November 23 equaled 
$1,426,000.) 

5. Possibilities of further expansion of deposit liabilities of 
member banks. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 273 

Supposing that the required reserve for member banks aver- 
ages ID per cent, and that the $1,377,494 should be used to the 
maximum amount to support their deposit grants to the public, 
an increase in these is possible of to 10 times $1,377,494 or 
$13,774,940. This represents a potential expansion of more 
than 90 per cent. (Total deposit liabilities of national banks 
on November 20, were $14,798,000.) An increase of note issues 
by $572,850 would probably furnish all the till money necessary 
to support the $13,774,940 of bank deposits. 

But even these figures do not show the full possibilities 
of credit expansion on this date. No account is taken of 
the huge surplus cash then reposing in the vaults of mem- 
ber banks. Much new gold, moreover, was to continue 
to accumulate in the vaults of reserve banks and many 
large and powerful State institutions were yet to enter 
the system. 

To what extent we may next inquire was this expansive 
power of the Federal Reserve utilized during the period 
of hostilities? The following figures show the amount of 
the total investment operations of reserve banks/ 

1917 

May $ 174,128,766 

June 887,502,360 

July 547,434,069 

August 297 023,452 

September 678,062,976 

October 2,770,806,092 

November 3,394,416,518 

December 1,137,104,390 

igi8 

January $1,525,984,729 

February 1,443.795.053 

March 1,993,080,060 

April 2,605,719,776 

* Figures do not include rediscounts and sales of discounted paper between 
Federal Reserve banks nor purchases of United States certificates of indebted- 
ness. See Report of the Federal Reserve Board, 1918, pp. 191-92. 



274 FEDERAL RESERVE POLICY 

May 3.309,207,111 

June 3.655»663,674 

July 3,490,037,616 

August 3.955.611,937 

September 4.953.969.540 

October 6,793,018,635 

November 5,569,708,767 

The following table shows the changes in the reserve 
banks' total earning assets, member banks* reserve ac- 
count, and Federal Reserve notes in actual circulation for 
various dates : ^ 





ooo's 


Omitted 




Date 


Total Earning 


Federal Reserve 
Notes in Actual 


Member Banks' 
Reserve 






Circulation 


Account 


1917 








April 27 


$ 239,260 


$ 420,509 


$ 719.785 


May 25 


287,297 


454.402 


813,326 


June 29 


494,536 


. 508,753 


1,033,460 


July 27 


411,978 


534,015 


1.135,456 


August 31 


381,063 


587,915 


1,069,804 


September 28 . 


504,937 


700,212 j 


1,136,930 


October 26 


684,959 


847,506 


1,264,323 


November 30 , 


1,052,377 


1,056,983 


1,489.370 


December 28 . . 


1,064,310 


1,246,488 


1,453.166 


1918 








January 25 . . . 


$1,029,670 


$1,234,934 


$1,480,743 


February 21 . . 


1,031,797 


1,314.581 


1,459,720 


March 28-29 • • 


1,201,585 


1,452,838 


1,499,400 


April 26 


1,286,162 


1,526,232 


1,497,416 


May 31 


1,301,390 


1,600,968 


1,440,413 


June 28 


1,345,112 


1,722,216 


1,557,587 


July 26 


1,564,540 


1,870,835 


1,435,196 


August 30 


1,716,987 


2,092,708 


1,478,639 


September 27 . 


2,080,566 


2,349,326 


1,535,490 


October 25 


2,295,122 


2,507,912 


1,683,499 


November 29 . 


2,312,359 


2,568,676 


1,488,893 



Some surprise may be evoked by the fact that the 
growth of the note issues was so much greater than that 
of the book credits granted to member banks. This is 

« See Reports of the Federal Reserve Board, 1917, p. 60; 1918, pp. 122 and 117. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 275 

explained in large measure, however, by the fact that the 
notes were being substituted for gold in the general circu- 
lation. The process was one by which notes were issued 
to meet member banks' counter-money needs and the 
gold of the reserve banks was being deposited with the 
Federal Reserve agents as cover. This is shown by 
the following figures; 

Gold Cover for Federal Reserve Note Circulation * 
(000,000's Omitted) 

Date 

1917 

June 29 3 402 

July 27 434 

August 31 493 

September 28 558 

October 26 614 

November 30 661 

December 21 746 

1918 

January 25 $ 793 

February 21 877 

March 29 852 

April 26 824 

May 3 955 

June 28 987 

July 26 910 

August 30 1,0x6 

September 27 1,161 

October 25 1,184 

November 29 1,216 

To a greater and greater extent the country*s gold was 
being drawn into the hands of the reserve agents where, 
according to the amendment of June 21, 19 17, it would be 
counted as part of the reserve banks' 40 per cent required 
reserve. By this process other gold in the reserve banks' 
vaults was released to serve as the reserve for deposit 
grants to member banks. 

' See Reports of the Federal Reserve Board, 1917, p. 47; 1918, pp. 97, 98. 



276 FEDERAL RESERVE POLICY 

The effect of the discount operations upon reserve 
banks' ratio of cash reserve to net deposits and notes is 
next indicated: 

Ratio of Total Cash Reserves to Net Deposits and Federal 
Reserve Notes ^ 
1917 

March 30 89.0 

June 29 75.4 

August 3 81.9 

November 2 69.0 

December 28 63.6 

1918 

February 21 66.0 

April 19 62.9 

May 31 62.0 

July I 59.8 

August 30 56.4 

November 22 50.5 

Great, however, as was this reduction in the reserve 
ratio, it would have been much greater had it not been for 
the new accretions of gold by the reserve banks. On April 
5-6, 19 1 7, for instance, the total gold holdings of reserve 
banks (gold in vaults plus gold with foreign agencies plus 
Gold Settlement Fund plus gold deposited with Federal 
Reserve agents as cover for the notes) was ?943, 552,000. 
On November 15, 1918, this total was ^2,056, 777. Credit 
and currency expansion were so great and so rapid that 
the huge surplus reserves of April 6, 19 17, would have 
fallen far short of meeting the demands. Only the attrac- 
tion of gold from the general circulation enabled reserve 
banks to maintain a favorable ratio. As it was, the reserve 
ratio fell approximately forty per cent in little more than a 
year and a half of hostilities. 

Let us next ascertain the effect of the war upon the 
operations of member banks. Between May i, 1917, and 

» See Reports of the Federal Reserve Board, 1917, p. 15; 1918, pp. 9, 10. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 277 

November i, 19 18, demand deposits of all national banks 
responding to the Comptroller's call ^ increased from 
?7,6i8,oi 1,000 to ?8, 640,8 18,000, or more than a billion 
dollars. Time deposits increased in the same period by a 
sum approaching ?300,ooo,ooo. Loans and discounts 
advanced in the same time from ?8, 75 1,679,000 to 
? 10,096,940,000, or approximately one and a quarter 
billion dollars. Total resources displayed a gain of 
y3»676,97i,ooo. 

In view, however, of the huge increase in reserve bank 
operations some surprise may be evoked because the in- 
crease of member bank advances was not even more large. 
Deposits with reserve banks comprise the legal reserves 
for member banks. Each dollar of deposits with a reserve 
bank forms the legal minimum reserve for many dollars 
of its own deposits. The advances of reserve banks furnish 
the basis for a several-fold expansion in member bank 
operations. 

We must recall the effect, however, of the amendment 
of June 21, 19 17, which required the deposit of all reserve 
money with reserve banks. As country banks transferred 
their funds from their city reserve agents to the reserve 
banks, the deposits of the city reserve agents diminished 
and those of the reserve banks increased. For instance, 
the condition of reserve banks prior to the amendment is 
indicated by the weekly statement of June 22, 19 17. On 
that date the reserve banks due-to-members account was 
?8o6, 209,000. The final transfer of reserves was com- 
pleted July 20, 19 1 7. On this date the reserve account of 
members had increased to ?i, 164,995. More than 
?350,ooo,ooo of reserve bank deposits represented the 

* See Comptroller's Report, 1917, vol. i, p. 35; 1918, vol. i, p. 16. Figures for 
May, 1917, are for 7,589 banks. Those for November i, 1918, are for 7,754 
banks. 



278 FEDERAL RESERVE POLICY 

shifting of reserves to reserve banks. So far as the increase 
of Federal Reserve note issues is concerned, it has been 
shown that they represented in large measure the sub- 
stitution of notes for gold in the general circulation. 

An increasing volume of currency and credit indicates 
one of several results.' First, it may point to a higher 
degree of industrial and business activity. If the general 
level of prices remains unchanged, greater production and 
more numerous exchanges necessitate an increased circu- 
lation of money. Secondly, the increased circulation may 
indicate, not greater economic activity, but rather a higher 
price level at which exchanges take place. Third, the 
enlarged circulation may indicate changes either in the 
amount of productivity or in the general level of prices. 
Let us next endeavor to ascertain in which direction the 
effect was felt most largely. 

The figures of the United States Bureau of Labor Statis- 
tics ^ show an enormous rise of wholesale prices in this 
period. Considering 19 13 as a base year the index number 
of wholesale prices for all commodities advanced as follows : 

1917 1918 

April 172 January .... 185 

May 182 February . . . 186 

June 185 March 187 

July 186 April 190 

August 185 May 190 

September . . 183 June 193 

October 181 , July 198 

November . .183 August 202 

December. . . 182 September . .207 

October 204 

November . .206 
* No account is taken here of changes in the rate of turnover of money. Un- 
doubtedly money was becoming more efficient in this period. The Gold Settle- 
ment Fund and the Federal Reserve Clearing System, for instance, lessened 
enormously the amount of money required to effect inter-bank balances. To 
the extent that the efficiency of money was increasing, we have another expla- 
nation of the rise in commodity prices. 
' Bulletin No. 269, July, 1920, pp. 16-19 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 279 

In the field of retail prices the movement for the same 
period is indicated by the following index numbers of the 
Bureau of Labor Statistics representing twenty-two 
articles of food : ^ 



1913 = 100 



1917 

April 145 

May 151 

June 152 

July 146 

August 149 

September . .153 

October 157 

November . .155 
December . .157 



1918 
January . . 
February . 
March . . 
April . . . . 
May ..... 
June... . 
July.. .. 
August . . . 
September 
October . . 
November 



.160 
.161 
.154 
.154 

.158 
.162 
.167 
.171 

.178 
.181 
.183 



Both wholesale and retail prices displayed an excep- 
tionally large advance. Let us next endeavor to ascertain 
whether the volume of trade increased in anything like a 
similar degree. Figures in this field cannot be accepted 
with so much confidence because the increase in business 
activity is bound up with that of increased prices. Bank 
clearings, for instance, may show no more the effect of 
increasing trade activity than the heightened price level 
at which exchanges of goods and services were made. This 
problem of entangling prices from the volume of business 
has been most successfully attempted, however, in statis- 
tics relating to the production of raw materials. According 
to figures contributed by Professor Wesley C. Mitchell, 
the following index numbers represent changes in the 
production of ninety commodities. In order to eliminate 
the effect of the change in the price level the value of all 
commodities is figured on the basis of 19 17 prices.^ 

* Bulletin No. 270, February, 192 1, p. 27. 
» Cf. Bulletin, April i, 19 19, p, 337. 



28o FEDERAL RESERVE POLICY 

Index Number of all Commodities 

Yearly Production Times 19 17 Prices 

1913 100 

1914 99 

1915 107 

1916 Ill 

1917 114 

191 8 116 

These figures would seem to indicate that the with- 
drawal of labor to the field and camp almost overcame the 
effect of speeding up industry by resort to the devices of 
more complete employment, longer hours for labor, and 
the bonus system. The year 19 18 shows only a slight 
increase over 19 17. While the field of production statistics 
has received little attention until recently these results 
agree sufficiently closely for our purposes with those of 
other statisticians. Walter W. Stewart, for instance, using 
19 13 as the equivalent of 100, shows the advance in 19 18 
over 19 1 7 to be one point (125-124).' 

These facts show that the enlarged media of exchange 
correlates more closely with the rise of commodity prices 
than with increasing trade activity. We may next inquire 
as to the causal relationship between the increase in the 
media of exchange and the advance in commodity prices. 

It is clear that the bond method of war finance resulted 
in an increasing money demand for goods. The part 
played by the banks in furnishing funds for bond pur- 
chases was such as to supply the means whereby the 
Government and the consuming public were brought into 
sharp competition one with the other. The Government 
was given credit not previously in existence, and this credit 
was employed fbr the purchase of labor and materials. So 
far as these became more scarce relative to the demands 

" Cf. W. W. Stewart, "An Index Number of Production," American Economic 
Review f March, 192 1, p. 68. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 281 

for them, the individual could secure them only by offering 
higher prices. It is true, however, that this was not the 
result of all types of Government bond purchases. If the 
individual purchased the Government bonds out of sav- 
ings, no enlarged money demand for goods was made 
possible. Credit previously possessed by the subscriber 
was transferred to the Government. To the extent that 
this enabled the Government to offer money for goods, 
the individual's demand must be lessened. The Govern- 
ment merely took the place of the individual and the con- 
ditions of demand were not greatly altered. 

But in many cases, war bond subscriptions resulted in 
something more than the mere transfer of existing bank 
credit from the bond purchaser to the Government. If the 
bond was bought by a bank, bank credit was given to the 
Government, but loans to the bank's customers need not 
be reduced. In case of a shortage of loanable funds, the 
bank had merely to call upon the reserve bank for a dis- 
count. In such a situation customers of the bank retained 
the funds they possessed before, and the Government 
entered the market with new credit to bid for goods. 

The same results followed when the individual hypothe- 
cated his bonds with his bank as collateral for a loan, or 
purchased the bond out of money loaned by the bank. In 
these cases the individual's bank account was not corre- 
spondingly lessened by the bond purchase, and the net 
result of the transaction was to furnish the Government 
with dollars in such a way as not to lessen the bond pur- 
chaser's ability to offer dollars for goods. Finally, if the 
bond was used itself as a medium of exchange, it operated 
in much the same way as Government paper money. 

The effect, however, of an enlarged monetary demand 
for goods need not necessarily result in higher prices. The 
increased demand may make possible production on a 



282 FEDERAL RESERVE POLICY 

larger scale in such a way as to lessen per-unit expenses. 
To the extent that competition prevailed in the industry, 
lower production costs would be reflected in lower prices. 

Slight reflection, however, is required to indicate that 
this could not have been the usual result. In order to 
remove labor from peace to war industries, the wage scale 
necessarily had to be advanced. New standards of labor 
remuneration were thus established which unionized labor 
insisted upon realizing elsewhere. The tremendous de- 
mand for war materials made it necessary throughout the 
industrial field to extend production to the relatively 
inefficient plant. There was much work for the marginal 
concern. These factors seem to have more than counter- 
balanced the economies occasionally realized of large-scale 
production. Enlarged demand necessitated greater per- 
unit expenses and accordingly higher prices. The only 
means of preventing such a result would have been to 
employ a method of war finance whereby advances of bank 
credit to the Government could be made only by lessening 
the public's command over dollars of credit or currency. 
The bond method obviously could not do this. 

It is no part of the purpose of the writer to elaborate the 
objectionable features of the war-time price advance. The 
difiiculties created, particularly for the unorganized 
worker, the bondholder, public utilities, endowed univer- 
sities and hospitals, in general for the recipients of rela- 
tively fixed incomes, have been sufficiently elaborated in 
popular discussion. It is fully understood, also, how the 
destruction of old standards of fair prices, standards which 
were the crystallization of past competitive conditions, 
made it virtually impossible for the consuming public to 
keep a close check upon the profiteer. Labor disturbances 
also and the consequent interference with war materials' 
production were frequently attributable to the worker's 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 283 

unwillingness to submit to a reduction in the real value 

of his wage. Altogether, price inflation enabled a small 
class of society to levy undeserved tribute upon the other 
classes. Profound and permanent changes in the social and 
economic structure of society were the inevitable results. 
Most of these changes, affecting extremely harshly the 
middle classes and the organized worker, were not such as 
to render easier the preservation of real democracy in this 
country's future. 

But the writer would prefer to emphasize two special 
aspects of the war-time price increase. In the first place, 
it rendered more difficult, if not impossible, the satisfac- 
tory solution of many international as well as of domestic 
post-war financial problems. Secondly, it retarded the 
speedy mobilization of this country's material and man- 
power for war. 

It was clear to careful observers that our post-war 
requirements would be such as to necessitate easy money 
and liberal credits. The release of soldiers from field and 
camp and the cessation of work in the munitions' factories 
would demand the rapid return of these men into indus- 
try. To fail to secure their speedy reentry must mean 
unemployment, discontent, and unrest. Accordingly, the 
post-war banking policy must be one of easy money rates 
and liberal credits. The banks should offer this stimulus 
to industry after the war. 

Every dollar of credit expansion during the war ren- 
dered this post-war relief more difficult, however. Even 
despite the sudden cessation of hostilities the war-time 
advance was such as to render a further increase almost 
unendurable to the non-entrepreneurial classes of society. 
As it was, prices got further out of line with each other, 
and the inevitable readjustment was rendered more 
serious. But if the war-time price advance could have 



284 FEDERAL RESERVE POLICY 

been retarded, a slight post-war increase, made possible 
by offer of liberal bank credits, could have been withstood 
with comparative ease. 

The price increase of the war period rendered more 
difficult also our post-war position as the world's banker. 
Despite the enormous advances to Europe made in the 
days following the signing of the armistice, there seems no 
doubt in the mind of the writer that we fell far short of the 
demands upon us. This should not be construed as mean- 
ing that we did not loan Europe sufficient sums for non- 
productive purposes. On the contrary, the writer feels 
that one of our greatest mistakes of the reconstruction 
days was our failure to restrict Europe's purchases to the 
goods needed for her industrial revival. We permitted 
her to dissipate her credit in the purchase of luxuries and 
consumption goods until the point arrived when her pur- 
chases must necessarily be restricted. Rather suddenly, 
American export industries lost their European market. 
There need have been no such loss of this foreign market. 
If Europe's purchases could have been confined to ma- 
chinery, necessary raw materials, production goods in 
general, her ability to continue to buy from us need not 
have been impaired. The resuscitation of her industries 
would have enabled her in time to purchase our goods 
through offer of the credits established throughout the 
world by sale of the products of her revived industries. 
But as it was, Europe used up her credit quickly without 
restoring her earning power. We could have afforded to 
loan far more to her had the credits been used for wise 
reconstruction purposes. The delay of reconstruction in 
Europe helped to usher in this country's depression of 
1920-21. 

But was price inflation necessary to win the war? Were 
not bond subscriptions necessary to furnish the dollars 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 285 

required by speedy mobilization and rapid war prepara- 
tion? Were not cheap rediscount rates necessary to 
enable banks to guarantee their customers the funds for 
their bond subscriptions? Could the twenty-odd billions 
of dollars have been obtained other than by a policy of 
inflation? 

Nobody would argue that any such colossal sum of 
money could have been obtained in any other way. If our 
total national annual income prior to the war was no more 
than fifty billions of dollars, for which estimate there is 
reputable statistical authority, nothing like fifteen or 
twenty billions a year could have been obtained by taxa- 
tion or borrowing from the public's savings. Our economic 
life was not so ordered as to permit the devotion of one half 
or one third our total income for war purposes. The only 
means of securing such a stupendous sum lay in direct 
or indirect bank advances. But under this method each 
dollar bought less than would the dollars contributed 
under a tax or huy-a-hond-out-of -savings-only programme. 

To secure the speediest mobilization of our war re- 
sources, the funds for military purposes should have been 
obtained from the existing volume of money and credit. 
The lessening of funds expendable for peace goods would 
have hastened the transfer of labor from the industries of 
peace to the industries of war. The most rapid shifting 
could be compelled only by lessening that portion of our 
income stream customarily spent for civil goods. Credit 
and currency expansion delayed the process of war 
mobilization. 

Since the war, when more leisurely reflection is possible, 
there has been an increasing disposition to accept these 
views. But these views, we are informed, represent judg- 
ment ascertained after instead of before the fact. They 
indicate only the hindsight of the parlor observer. In order 



286 FEDERAL RESERVE POLICY 

to make clear the writer's position in this matter, he would 
like to quote from an article prepared by him in the winter 
of 19 1 7-1 8 in the midst of our warlike preparations: * 

To what purposes, then, should the reserve banks' surplus 
gold be put? Should it be used at the present time to enable 
member banks to increase their loans to the business pubHc, 
or should it be carefully husbanded to meet post-bellum re- 
quirements? Now is the time when this question of policy must 
be met squarely. The Board that controls the largest surplus 
stock of gold the country has ever held surely ought not to con- 
tent itself with mere day-to-day decisions. Let the maximum 
amount of credit be extended to-day and heightened commodity 
prices will render this gold unavailable for later purposes. More 
bank loans, and consequently more gold, will be needed to 
finance the same volume of transactions. Deflation can take 
place only slowly and gradually and with resultant depression 
to business. 

In the minds of the great majority of the people the Board 
can make but one choice. We are reminded that the present 
need for funds exceeds that of any previous period, that the 
gravity of the war situation demands that every possible dollar 
be used to meet existing requirements regardless of any oppor- 
tunities to come. National defense, we are told, supersedes all 
future trade advantages. By liberal offer of its credit the Board 
should quicken, therefore, the course of present industry. If 
inflated prices result, these must be accepted as part of our 
sacrifice to the cause of democracy. 

Each day, however, the fallacy of this view grows more obvi- 
ous. It is becoming clear that the production of war supplies is 
fundamentally not a problem of securing dollars, but rather one 
of commandeering labor and materials. The real problem of war 
finance is to shift labor and equipment with the least possible 
delay from the unessential to the necessary war industries. No 
matter what financial programme is adopted, it is clear that only 
by restricting the operations of the non-war Industries can there 
be the largest possible Increase In the production of military 

^ Cf. H. L. Reed, "Credit Expansion under the Federal Reserve," American 
Economic Review, June, 19 18, pp. 270-82. 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 287 

supplies. The stream of purchasing power that ordinarily flows 
to the one must in large measure be transferred to the other. 
The quickest transition can take place, not by increasing the 
total volume of bank dollars, but by diverting dollars from 
former fields of expenditures. The funds for financing war indus- 
tries and activities should be obtained in largest part from the 
existing volume of money and credit. 

In the last analysis the real gain from economizing our gold 
does not arise from an internal expansion of credit. By virtue 
of price adjustment domestic industry can accommodate itself 
either to a large or to a small volume of bank credit. The ad- 
vantage of refining our credit system results rather from foreign- 
trade operations. To support our credit structure with less gold 
releases the surplus for foreign purchases, virtually enabling us 
to obtain the products of foreign industry without the expendi- 
ture of labor or the sacrifice of material on our part. To the 
extent, therefore, that foreign countries are not in a position to 
sell to us to-day, our surplus gold should be retained for post- 
bellum needs. In the measure that we use this gold at the pres- 
ent time to support domestic loans, and thereby inflate the 
general level of prices, we lose our power to reap the final and 
ultimate gains. 

Inflation is sometimes defended on the ground that 
rising prices have a stimulating effect upon industry. So 
much accustomed are we to think in terms of dollars, 
rather than in terms of their purchasing power, that an 
increase of money incomes may exert a favorable psycho- 
logical effect upon business and labor. As David Hume 
once described the effect of the gold and silver discoveries 
of the sixteenth century : ' 

Accordingly we find that, in every kingdom into which money 
begins to flow in greater abundance than formerly, everything 
takes a new face: labor and industry gain life: the merchant 
becomes more enterprising, the manufacturer more diligent 
and skillful and even the farmer follows his plow with greater 
alacrity and attention. 

' Essays, Moral, Political and Literary. 



288 FEDERAL RESERVE POLICY 

This argument was scarcely applicable, however, to the 
period of our participation in the war. Our financial 
problem was as much to repress the industries of peace as 
to stimulate the industries of war. The rising prices stimu- 
lated the unnecessary quite as much as the necessary war 
industries. Rapid preparation for war could come only 
by withdrawing capital from the industries of peace at the 
same time that funds were being made available for those 
of war. 

There is no doubt but that the general public was un- 
prepared for heroic financial measures. Our patriotism is 
a curious thing. It is fit that men be conscripted to die 
upon the firing line. It is not fit that there be conscription 
of the civilian's income, not his capital, to equip the sol- 
dier. Yet those who resist taxation, the logical method of 
transferring funds from civil to war expenditures, are the 
stuff out of which war heroes are made ! We seem to prefer 
to bear the financial burden of war indirectly, rather than 
directly, in the form of higher living costs. But this sort 
of a sacrifice is most inequitably imposed upon the people 
of society. 

Would it have been possible, however, to educate the 
public to the fact that the bond method, in the same 
manner as any other, involves a real burden which the 
public cannot shift to another generation by borrowing 
from its own people? In the last analysis the economic 
burden of war consists in the using up of commodities and 
human services for purposes of destruction, thus lessening 
the volume of production for civil uses. Selling bonds to 
its citizens does not mean the shifting of the burden to a 
future generation. An internal debt is not a burden for a 
people as a whole. To the extent that some are taxed to 
pay the interest and the principal of the bonds, others 
benefit by receiving these taxes in the form of bond inter- 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 289 

est and principal repayment. If bonds are not in the next 
generation a burden upon the people as a whole, there 
could be no shifting of the burden from the generation 
which witnessed the conflict. 

It may be that it would have been impossible to secure 
general confirmation of these simple economic principles 
by the ordinary processes of education and propaganda. 
But if so great attention had not been drawn to the virtu- 
ally unlimited supply of dollars in the reserve bank reser- 
voirs, the necessity of higher taxes and more restrictive 
rationing methods would have become apparent much 
more early. Gradually we should have seen that a modern 
world war necessitates financial as well as military con- 
scription. But the part played by our public authorities 
was such as to deaden our perception of these facts. We 
were encouraged to buy bonds on such terms as inevitably 
to create price inflation. Individual subscribers were 
offered funds indirectly obtained from the Federal Re- 
serve; banks virtually were informed that they would be 
protected by the Federal Reserve banks against over- 
subscription on their own part or on the part of their cus- 
tomers. Everything possible was done to lull instead of to 
arouse a spirit of critical analysis by the public. 

But what was the responsibility of the Federal Reserve 
administration in all this? Should the Federal Reserve 
Board have refused to cooperate with the Treasury? 
Should it have based its rediscount policy upon general 
banking and financial considerations alone and have 
ignored the Government's fiscal programme? Should the 
reserve banks have ignored the bond issues in the forma- 
tion of their discount policies? 

Only slight consideration is required to indicate the 
undesirability of any hostile attitude. During time of war 
the various governmental agencies cannot refuse mutual 



290 FEDERAL RESERVE POLICY 

cooperation. They cannot work at cross-purposes. Con- 
gress had sanctioned the bond method of war finance, and 
the treasury undoubtedly acted in accordance with the 
general point of view in recommending the *' low interest" 
policy. When Congress enacted the Federal Reserve Act 
it provided specifically for ex-ofiicio membership on the 
Board of the Secretary of the Treasury and the Comp- 
troller of the Currency. Was not this the expression of its 
desire that there be close cooperation between the Treas- 
ury and the reserve banking authorities? 

From the standpoint of political expediency it would 
have been extremely unwise for the Reserve Board to have 
refused full cooperation with the Treasury. From the 
time of Andrew Jackson the public has accepted the dic- 
tum that the management of a central banking system 
must consider itself a servant of public authority. During 
the World War it could not have established for itself an 
independent position. 

Whatever responsibility can be placed on the shoulders 
of the Board, therefore, can only be those resulting from 
its encouragement of an unsound financial policy. The 
final question to be investigated, therefore, is whether or 
not the Board's counsel was such as to encourage infla- 
tionary tendencies. 

There is no doubt regarding the Board's position in this 
matter. Throughout the war it preached the doctrine of 
conservation of credit as well as of goods. To quote from 
its official pronouncements in the January I, 19 18, 
Bulletin : ' 

Events are, however, every day making it clearer that the 
conservation of our financial strength is not of itself sufficient 
to ensure the successful financing of the war. The financing 
of the war is only in part a money problem ; in very large part 

» Pages 2, 3, 



DEVELOPMENT, MAY, 1917, TO NOV. 11, 1918 291 

it is an economic problem — a problem of conserving the 
economic as well as the financial strength of the Nation. . . .; 

Nobody should, therefore, consume goods except to the extent 
that their consumption is necessary to maintain health and 
vigor; 

Let the public realize that it is more respectable in such war 
times as confront us to be seen in old clothes than in new ones. 
Let the banks tell the people of their communities and their 
authorities, the mayors and governors, that this is not the time 
for cities to be spending money on public works. . . . ; 

... it must nevertheless be our constant concern to keep 
every dangerous tendency in the banking situation under con- 
trol and particularly to retard the too rapid expansion of bank- 
ing credit. . . . 

The effectiveness of such implorations may well be 
questioned. Spending cannot be lessened while the means 
of spending increase. Nevertheless, the Board's record, 
during this period, was clear. Whatever the evils of the 
easy-money policy of war finance the responsibility can- 
not be laid at its doors. The fault was that of the Treas- 
ury, of Congress, and of the people. So infrequently does 
war occur that the requirements of successful war finance 
are not generally understood. No nation ever taxed itself 
sufficiently highly during a great war. Any other policy 
must be inflationary. During the Civil War the inflation 
was a matter of greenback issues. During the World War 
it was a matter of note issue and bank credit expansion. 
But throughout this period the reserve banks were merely 
financial instruments through which the Treasury en- 
deavored to accomplish its aims. 



CHAPTER XV 

FEDERAL RESERVE DEVELOPMENT, NOVEMBER 12, 

1918, TO MAY, 1920 
THE PERIOD OF POST-WAR CREDIT EXPANSION 

After the signing of the armistice, the industrial outlook 
was extremely uncertain. It is true that most of the long- 
time forces seemed to point toward the early resumption 
of general prosperity. The labor and the materials that 
had been utilized for war purposes would now be available 
to supply our normal wants, and, moreover, the cessation 
of hostilities enabled industries to be freed shortly from a 
host of restrictive measures. Gradually embargoes upon 
certain articles of export were removed, the list of pro- 
hibited imports reduced, and the priority rules established 
under the rationing policy of the War Industries Board 
abandoned. Shipping was increasing in quantity, building 
and construction were no longer to be discouraged by 
public authority, and the war restrictions relating to the 
securing of investment capital for private enterprise were 
repealed. With these fetters removed, it appeared that 
the general economic welfare soon would improve.^ 

Expressions of confidence frequently overlooked, how- 
ever, the fact that in our existing economic society indus- 
trial activity depends upon the volition and the appraisals 
of the entrepreneur. If he does not feel the situation ripe 
with profit-making possibilities, industrial stagnation is 
our lot. Instead of demobilization increasing the more 
complete utilization of our labor force, it might mean 

^Cf. H. L. Reed, "The Industrial Outlook," Journal of Political Economy ^ 
April, 19 19, pp. 225-40 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 293 

merely the recruiting of the army of the unemployed. The 
essential question at the close of 19 19 was whether or not 
industrial and financial conditions were such as to arouse 
enthusiasm on the part of the entrepreneur. 

In very many respects the situation was cloudy. Money 
wages of the laborer had increased far above their pre-war 
level and it did not appear that they could be reduced 
quickly. Organized labor appeared determined to hold 
what it considered to be the gains of the war period, to 
insist upon the prevailing wage scale even though com- 
modity prices should fall to a lower level. It is true that 
the manner in which wages were increased was frequently 
such as to offer hopes of speedy reduction. The elimina- 
tion of extra hours of labor would remove the necessity of 
paying high rates for the products of the hours of greatest 
fatigue. With the suspension of work in the war industries 
the employer's bargaining power would be still further 
increased. A strike could take place only in a situation 
where many unemployed would be looking on. The return 
of soldiers, moreover, would enable the employer to take 
his pick and select only the fit. During the war, labor costs 
were high, not merely because of the high money wages, 
but also because employment had to be offered to the most 
inefficient of the labor group. Nevertheless, there was the 
likelihood that the life of the soldier had been such as to 
unfit him for steady work in monotonous tasks. War 
necessarily creates a spirit of unrest and independence, 
not consistent with strict industrial discipline. 

As to finding markets for industry's products there 
appeared to be much less uncertainty. The economies of 
the war period left many demands unsatisfied. Work on 
the roads, on buildings, on capital equipment of various 
sorts, could not continue to be neglected. In the course of 
time the Government demand for investment funds would 



294 FEDERAL RESERVE POLICY 

relax and enable a part of society's income stream to be 
redevoted to the purchase of neglected goods and services. 

In one way it was particularly fortunate that a large 
portion of our soldiers did their fighting three thousand 
miles from the United States, and that many months 
elapsed before all of them could be returned home. In- 
dustry was not required to plan for the immediate absorp- 
tion of all of these millions. Demobilization began with 
certain special units in this country and was extended 
gradually. As the men first discharged worked their way 
into industry, their own wages would help to create the 
demand for the production of other goods. By the time 
the divisions from the battle front returned, industry 
might be revived sufficiently to offer them general 
employment. 

From the banking standpoint the situation was some- 
what more hopeful. At the close of hostilities the reserve 
ratio of the reserve banks was approximately fifty per 
cent. It would appear that this would be sufficient to 
guarantee ample funds for a moderate volume of new 
financing. It was true that the expenditures of the war 
had not terminated. One new bond issue was yet to be 
offered to the public, and it was plain that for some time 
the Treasury must appear in the loan market as a bidder 
for investment capital. There were also certain possibili- 
ties of a considerable drain of gold from the reserve bank 
reservoirs. During the war the embargo upon gold pre- 
vented us from balancing our indebtednesses by shipments 
of the money metal, particularly to the neutral countries 
of Europe and to certain nations of the Orient. Unpaid 
balances as well as new indebtedness might create a heavy 
demand for this purpose. It might be that our inability 
to collect gold from the warring nations of Europe might 
subject us to a loss of gold even though our general trade 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 295 

balance was favorable. But all in all the sudden termina- 
tion of hostilities left our banks in fairly good shape. 

It was in the matter of prices, however, that the greatest 
uncertainty existed. There was grave doubt everywhere 
as to whether the war level could be maintained. Un- 
doubtedly the common prediction was that the removal of 
war conditions would destroy the cause of the high prices, 
and that in a short period the restoration of production 
would bring about their decline. It is true some difficulty 
was experienced in explaining how there could be enhanced 
production in a situation of tumbling prices. Would not 
weakening prices destroy the entrepreneurial incentive 
to productive activity? The general feeling, nevertheless, 
seemed to be that the war level was an abnormal level, 
and that normal conditions would mean the return of the 
pre-war level. 

Such, for instance, was the prediction of Mr. B. M. 
Anderson. To quote from his argument: ^ 

The belief that there will be a drastic drop in prices is based 
on obvious conditions. With a vast volume of labor rapidly 
being discharged from munition factories the world over to 
resume the production of normal supplies; with steel, copper, 
coal, shipping and other essentials released; with 50,000,000 
soldiers returning to farms and factories, there will be an 
immense increase in the volume of goods available for civilian 
consumption. Prices should fall, even before this actual trans- 
formation is carried far, because wholesale markets commonly 
forecast impending changes. 

It must be admitted that the price movement, shortly 
after the armistice, tended to confirm these views. The 
wholesale price index of the Bureau of Labor Statistics 
showed for December, 191 8, a decline in the clothing, 

* "When War Ends and Prices Drop," Economic World, November 23, 1918, 
p. 727. 



296 FEDERAL RESERVE POLICY 

metal, and chemicals groups.' Both in January and in 
February the index for all commodities fell somewhat. 
The first two months of 1919, moreover, displayed a de- 
cline in the index number of retail food prices.^ 

In the belief that a continuous price decline was in- 
evitable, certain projects were launched for the purpose of 
hastening the return to the "rock-bottom" level, the level 
at which industry could figure upon the immediate revival 
of activity. No positive achievements resulted from these 
projects, but there was no disposition to impose harsh 
restrictions upon industry. The Federal Reserve banks 
held their rates low. For January, 1919, the average rate 
charged on all paper discounted by the reserve banks was 
4.18 per cent and for February 4.14 per cent.^ 

In a short time, however, it appeared that predictions 
of price decline were not to be fulfilled. Both in March and 
in April the all commodities wholesale index of the Bureau 
of Labor Statistics showed a slight increase, and the 
expected (difficulties of finding employment for the 
returned soldiers did not seem insurmountable. Undoubt- 
edly most observers were amazed at the rapidity with 
which industry adjusted itself to the new conditions. It is 
probable that not one tenth as much discussion was heard 
of the problems of reconstruction as had been anticipated. 
The May, 19 19, Bulletin noted that price recessions had 
not been as rapid as predicted. It stated : ^ 

What Is now happening seems to Indicate that business will, 
after a period of Initial readjustment In prices, proceed upon a 
level not far removed from that established during the war, 
leaving the question as to the ultimate level of prices to the 
future and to more slowly acting forces. 

» See Bulletin 1^0. 269, July, 1920, pp. 16-19. 

" See Bureau of Labor Statistics, Bulletin No. 270, February, 192 1, p. 27. The 
index numbers are made up of the prices of twenty-two articles of food. 
3 Report of the Federal Reserve Board, 1919, p. 176. ^ Page 411. 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 297 

Various were the explanations which were offered for 
this unexpected firmness of prices. For one, the foreign 
demand for our products proved much stronger than 
anticipated. Also during the war, the prices of many 
commodities had been held artificially low by the price- 
fixing activities of Government agencies. When the 
restrictions were removed, supply and demand conditions 
were such as to exert a tendency for these prices to move 
to a higher point. On the part of entrepreneurial manage- 
ment there was undoubtedly also a recognition of the fact 
that the time was not opportune for a conflict with labor, 
that since labor insisted upon a high level of money wages 
it would be best for the time being to proceed upon the 
assumption that wages were not to be reduced. Wages 
could be put in proper relation to other prices by per- 
mitting the general level to advance. But whatever the 
correct explanation, it was recognized generally by the 
spring of 19 19 that the period of price uncertainty was 
over and that the industrial barometer pointed toward 
increasing activity. 

The financial events of the following year are now well 
understood in their general outlines. The country was to 
experience a rise in prices, an expansion of currency and 
credit, and a boom in industrial and speculative activity 
which exceeded by far even that of the war period. This 
is indicated by the following facts: 

April 25, 1919, the reserve account of member banks 
with reserve banks was ?i, 664, 320,000. April 23, 1920, it 
was ?i, 859,062,000, a gain of pearly ?20o,ooo,ooo. In the 
same period the circulation of Federal Reserve notes 
increased more than ^500, 000,000 and earning assets over 
?8oo,ooo,ooo. On May 12, 1919, the Comptroller's reports 
show loans and discounts for 7773 national banks to be 
^9,904,82 1, 000. May 4, 1920, 7990 national banks pos- 



298 FEDERAL RESERVE POLICY 

sessed loans and discounts of ? 12, 288, 582, coo. This was a 
gain of more than two and a third million dollars. The 
activity on the stock exchanges, the boom in security 
prices, the rise of call-money rates exceeded past prece- 
dent. In the field of wholesale prices the movement was 
as follows: 

Bureau of Labor Statistics' Index Numbers of Wholesale 
Prices for All Commodities. Base 1913 = 100 

1917-March 161 

1918-March 187 

1919-March 201 

April 203 

May 207 

June 207 

July 219 

August 222 

September 221 

October 222 

November 230 

December 238 

1920-January 248 

February 248 

March 253 

April 266 

May 272 

In view of the fact that this currency and credit expan- 
sion was so great as to cause the reserve ratio to fall from 
71.7 per cent on May 2, 1919, to 43 per cent on May 7, 
1920, and that on many occasions the New York Reserve 
Bank's ratio ^ was on the margin of falling below the legal 

^ A slight change in the method of computing reserve banks' reserve ratio was 
introduced February 12, 1920. Regarding this the January, 1920, Bulletin 
(p. 3) states: "Beginning with February 12, 1920, the reserve to be carried by 
Federal Reserve Banks against deposits will be computed against immediately 
available deposits only. Items on the liability side whose availability is deferred 
and uncollected items on the resource side of the bank statement will be dis- 
regarded in determining the liability upon which reserve is computed. This 
action will tend to apply a more severe standard of computation, especially in 
the case of those banks which have been carrying a relatively large float. " 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 299 

minimum, some astonishment may be evoked because the 
reserve administration permitted this enormous expansion 
of credit and currency. It should be emphasized that this 
expansion rendered possible an unexampled ^ price in- 
crease in time of peace. It had generally been expected 
that the post-war era would witness an attempt to return 
to pre-war conditions.* As stated in the Bulletin for 
March, 1919:^ 

The era of inflated prices maintained by aid of legislation or 
by Government administrative action thus draws to a close, and 
the aim to be sought is not that of perpetuating war conditions, 
but that of returning to a stable footing upon the terms and con- 
ditions that would be just and fair to all concerned. There is 
much agreement with the Secretary of the Treasury in his 
statement that the readjustment must begin with a reduction 
in the cost of living to the consumer, sorely tried as the latter 
has been by the great inflation of prices and the additions made 
to his living costs in many directions. 

It should be kept in mind, furthermore, that in the latter 
part of 19 19 many speculative excesses were commonly at- 
tributed to the rapid growth in the volume of bank credit. 

Explanation of the credit policy of the reserve adminis- 
tration may be attempted by considering the following 
suggestions : 

First, the short-time fiscal requirements of the Govern- 
ment were such as to cause the Treasury to demand 
easy money rates. 

Secondly, there was the fear that higher rates would 
work a hardship upon the holders of the war bonds by 
depressing further the market price of their securities. 

Thirdly, it was believed that easy credits were neces- 

* Unexampled in this country since the greenback era. 
' As stated in the previous chapter, the writer does not believe this would have 
been good policy. 
J Page 191. 



300 FEDERAL RESERVE POLICY 

sary to enable industry to readjust itself quickly to the 
new conditions. 

Fourthly, there was a failure to perceive the correct 
relation between expanding credits and rising prices in a 
period of great industrial activity. The theory was appar- 
ently accepted that prices were determined by other forces 
than the volume of currency and credit. 

Fifthly, a restriction of credits would have been politi- 
cally unpopular. The public does not understand the 
necessity of restraint in the manufacture of bank credit. 
Its complaints are directed most largely against the results 
of an unduly rapid expansion and not against the expan- 
sion itself. 

Sixthly, there was much doubt as to the effectiveness of 
the weapons possessed by reserve banks to curb continu- 
ous increases in the reserve banks. In no previous period 
of Federal Reserve operation had restrictions been em- 
ployed vigorously. Precedent and experience were lacking. 

In regard to the short-time fiscal requirements of the 
Treasury, it will be recalled that the Victory notes were 
issued in the spring of 19 19, and that in the succeeding 
months the Treasury continued to meet its current re- 
quirements by selling low-interest-bearing short-time 
certificates. To have increased rediscount rates on paper 
collateraled by these issues would have rendered their sale 
difificult. It will always be a grave question as to whether 
the continuation of the low-interest policy was justified. 
Despite the depreciation of the dollar, it is probable that 
such a policy was to the immediate advantage of the 
Treasury. Since a large portion of the Government's 
disbursements were fixed in terms of dollars, its expendi- 
tures did not increase proportionately with the decline in 
the value of the dollar. 

Whether or not there was warrant for subordinating 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 301 

banking considerations to Treasury requirements is an- 
other matter. But as the situation developed it was not 
until after January, 1920, when the Treasury gave up its 
policy of floating certificates at abnormally low rates, that 
considerations of banking policy became the controlling 
factor. 

But Government finance exerted its influence in other 
guise than in the Treasury's short-term requirements. It 
was understood that the market quotations ot war bonds 
must be further depressed if rediscount rates were in- 
creased. If member banks could not rediscount paper 
collateraled by war bonds, the banks could not carry the 
subscribers without loss. Was not the Government mor- 
ally obligated to protect those who had heeded its call to 
borrow and buy bonds? 

Thorough analysis seems to indicate that there was no 
possible manner in which the interests of these bondhold- 
ers could be protected fully. Bond prices could be upheld 
only by a policy of inflation. But inflation meant a de- 
cline in the purchasing power of the dollars realized by the 
sale of the bonds. What if they did sell near par? The 
proceeds would purchase less and less either in other secur- 
ities or in goods, the greater the depreciation in the pur- 
chasing power of the dollar. In other words, the sacrifice of 
the bond-buyer in purchasing low interest securities must 
mean loss to him. No policy of inflating to keep money 
rates low could avoid this loss. Only an ease in the money 
market, determined freely and without artificial control, 
could aid him. 

Those connected with the Treasury have not hesitated, 
however, to defend its policy on the ground of war neces- 
sity. To quote from R. C. Lefiingwell, Assistant Secretary 
of the Treasury : ^ 

« See American Economic Review, March, 192 1, pp. 30-36. 



302^ FEDERAL RESERVE POLICY 

During the whole period of the war any attempt of the 
Federal Reserve Board to control credit through rates would 
have been futile. The Treasury would have had to meet any 
rate they made at home, and the federal reserve bank rate could 
have no effect upon the international situation, because the 
international movements of goods, gold, and capital was con- 
trolled by foreign governments or our own for the purposes of 
the war. The adoption of a "dear money" policy during the 
war, with a view to preventing inflation would have failed of 
that purpose unless it had been carried to such an extreme as to 
bring about such conditions in war time as exist to-day, in which 
case we should have lost the war and would have had to inflate 
afterwards in order to pay the indemnity which Germany would 
have imposed upon us. 

If Lefifingwell means by this that a higher rate on bonds 
would not have enabled the Government to obtain many 
more dollars from the bond subscriber, we may express 
agreement. To a very large extent considerations of 
interest and income were ignored by the bond-buyer in 
the making of his subscription and a higher rate might not 
have attracted greater purchases. No matter what the 
rate, the national income was not large enough to permit 
a large portion of the subscriptions to be made from 
savings. Banks were obliged to advance a large part of 
the funds, expecting individual subscribers to take them 
up at a later date. But to the extent that these considera- 
tions are true, we have another argument against relying 
upon borrowing as the chief means of securing war reve- 
nues. At an earlier date heavier taxation would have 
aided the process of speedy mobilization and would have 
confined the financial disturbances more largely to the 
period of hostilities. 

But to continue LefBngwell's statement: 

After the war was over in the fighting sense, It went right on 
in the Treasury sense. We reached the peak of expenditures in 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 303 

the three months, November and December, 1918, and January, 
1919. We spent two billion dollars a month. That was as much 
as the First Liberty Loan each month. Since armistice day 
this Government has paid out as much as before armistice day, 
twenty billions before and twenty billions after. The gross debt 
of the Government on armistice day was eighteen billions. Nine 
months later it was twenty-six and a half billions. While the 
Government debt was mounting thus, the same condition 
continued which had existed during the period of active warfare. 
It was no more practicable to exercise control of credit by the 
use of dear money than it had been before. Indeed, it was less 
practicable, because the enthusiasm, devotion and self-sacrifice 
of the American people while war was on vanished over night 
with the signing of the armistice. The bills did not get paid any 
easier, but a good deal harder, because the Germans had 
capitulated. 

And further: 

Though something may be said for the view that In the latter 
part of 1 9 19 there might have been a somewhat earlier and 
greater advance in rates on commercial paper and in the open 
market buying rates for acceptances, my own judgment is that 
this is a question of detail rather than of substance, and that the 
effort to make money really dear before January, 1920, when the 
Government was first able to reduce its floating debt to manage- 
able amounts and maturities, would have risked more than it 
could have hoped to gain. 

The undesirability of any pronounced increase in re- 
discount rates, as well as in the rates borne by the Treas- 
ury certificates in the post-war period, seems clear to the 
writer. But the matter of a slight increase at a date prior 
to the fall of 19 19 appears to be something more than a 
mere matter of detail. While the enhanced cost of bank 
credit in and of itself might not have been of great effect 
upon industry it would have furnished the most forcible 
statement possible of the reserve administration's dis- 
content with the existing situation, and of its purpose to 



304 FEDERAL RESERVE POLICY 

restrict credits as soon as the condition of the Treasury 
made such action possible. It might have prevented so 
thin a stretching of the speculative bubble. Despite the 
warnings of the Federal Reserve Board and of the reserve 
bank directorates, very many came to look upon the 
reserve system in the wrong light. For the first time in the 
period of reserve operation, rediscounting began to be 
considered generally as primarily a means of securing 
funds for profit-making opportunities. As stated by the 
Board in its April, 19 19, Bulletin: * 

Already some well-managed member banks are showing in 
their statements the extent to which they are in debt to Fed- 
eral Reserve Banks. It has been the opinion of the Board that 
the borrowing of member banks at Federal Reserve Banks 
might very easily be carried to excess, the loans being placed 
there primarily for the purpose of profit and not for any more 
general public or fundamental object. In a general letter to 
banks, issued on November 19, (1918), and referred to in the 
Federal Reserve Bulletin for December, the Board took occasion 
to caution member banks which it was thought were in some 
danger of overdoing their rediscounting, that the purpose of 
such rediscount operations was not primarily that of assisting 
the member institutions which placed the rediscount to obtain 
the funds for further profitable operations, but was rather to be 
determined upon the basis of general banking advantage or 
upon that of relief for banks which found themselves hard 
pressed or were suffering from reductions in reserve account. 

The writer does not believe, however, that such warn- 
ings as these were interpreted very seriously. Without 
positive action in the form of rate increases they seem to 
have been regarded merely as indicative of the Board's 
viewpoint, a viewpoint not likely to warrant coercive 
measures. The crisis of 1920-21 was due to many causes. 
One of these was excessive commodity speculation which 

« Page 311. 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 305 

was fanned by the belief that credits would continue to 
remain cheap. The only way to dissipate this belief would 
have been to raise rates before the bull movement had 
spread far. 

An increase of a half per cent or so on the Treasury's 
short-term borrowings would not of itself have been an 
important consideration. A few millions of extra charges 
would have been a negligible consideration compared with 
the losses suffered by this country in the industrial collapse 
of 1920-21. Part of these losses might have been prevented 
by initiating at an earlier date a policy of rate increases. 

Strengthening, however, the view that rates should be 
kept low was the desire to enable industry to readjust 
itself quickly to new conditions. It was a matter of supply- 
ing the stimulus of easy credits. Not until the summer of 
1919 was there manifested any strong disposition to look 
at the matter from the standpoint of the consumer's 
interests. In the general demand for lower living costs 
which followed the Railway Brotherhoods' insistence that 
either their wages should be increased or the cost of living 
lowered, there was manifested a general inclination on the 
part of those prominent in the reserve administration to 
lay the emphasis upon the necessity of wage revision 
rather than upon a reduction in prices. Mr. A. C. Miller, 
a member of the Federal Reserve Board, declared, for 
instance, that 

Some mechanism by which wages may promptly be adjusted 
to changes in the cost of living must be accepted as an essential 
part of the American wage system.' 

He did not state what should be done to relieve the recipi- 
ent of a fixed income, the bondholder, the bank depositor, 
the endowed university or hospital. 

« Cf. Bulletin, October I, 1919, p. 915. 



306 FEDERAL RESERVE POLICY 

Prior to the cost-of-living controversy in the summer of 
19 19 there had been no clear statement of the Board's 
position regarding the relation of an increasing volume 
of currency to the general level of prices. But on August 8, 
19 19, in a letter replying to an inquiry of the Senate Com- 
mittee of Banking and Currency, Governor Harding 
expressed his views on this question. To quote a brief 
extract from Governor Harding's statement : ^ 

The difficulty, indeed the impossibility, of keeping in circu- 
lation an excessive volume of Federal Reserve notes should be 
understood. . . . They are issued only as need for them devel- 
ops, and as they become redundant in any locality they are 
returned to the Treasury at Washington or to a Federal Reserve 
bank for redemption. Thus there cannot be at any time more 
Federal Reserve notes in circulation than the needs of the coun- 
try at the present level of prices require. 

In other words, the volume of note issues depends upon 
the height of prices. Instead of the volume of currency 
determining the general level of prices, it is a matter of the 
level of prices determining the height of the price level. 

Because the increase in circulation of notes had exceeded 
the increased grants of book credit to member banks, 
Harding's communication dealt almost entirely with note 
issues. It appears to the writer, however, that the same 
position must be taken regarding deposit credits granted 
by member banks. The underlying theory of Federal 
Reserve note issues was that the notes should be emitted 
under regulations more similar to those governing deposits. 
In reality the nature of the note and the deposit are 
identical. They both represent ways by which banks may 
create credit or credit money. It is true that the note 
possesses a greater circulation power and is needed by 
banks to avoid losing reserve money on occasions when 

» Bulletin, August i, 1919, p. 699 ff. 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 307 

there is a drain on counter money. But so far as their 
effect on prices is concerned, and that is the question now 
under discussion, both must be regarded as part of the 
general circulating medium. 

If this theory be true, that the volume of the circulating 
medium depends upon the height of prices, the reserve 
administration's responsibility would appear to be lessened 
considerably. It never could issue more Federal Reserve 
notes than the ** needs of the country at the present level 
of prices require." Its policy in creating credits or cur- 
rency could never be attacked. Prices are determined by 
other factors and other causes, without direct regard to 
the acts of the reserve administration. 

Since this theory, if accepted, would relieve the Board 
of many attacks and adverse criticisms, it is not surprising 
that the Board was inclined to emphasize it. But is it 
true? 

Viewed superficially, the theory appears to be correct. 
Every business man knows that there are countless trans- 
actions in which prices are agreed upon first, and that the 
bank credit to satisfy the purchaser's indebtedness is 
granted later. In such situations it appears that the 
height of prices, independently fixed, determines the vol- 
ume of credit later to be created. But what led our buyer 
let us say a retail dealer, to agree to pay such and such a 
price? The principal consideration was whether so high a 
price must be paid to get the goods, and whether the 
demand of consumers would be sufficiently strong to en- 
able him to unload at a profit. It requires but a moment's 
analysis to demonstrate that both of these factors are 
subject to influence by the banks in their grants of credit 
to the business public. 

Why did our dealer agree to pay the stipulated price? 
Obviously, because the seller of the goods could obtain a 



3o8 FEDERAL RESERVE POLICY 

favorable price elsewhere. What enabled other dealers to 
bid up prices for the goods? Obviously, it was a matter of 
the general volume of currency or credit at their command. 
In the creation of this credit, the banks elsewhere played 
their part in determining the strength of the outside com- 
petitive demand. If they had been more illiberal in their 
advances, our buyer could not have been compelled to 
offer so high a price. 

It is also clear that banks* advances help to determine 
the terms on which the dealer can unload his goods. The 
credit first advanced to him in the making of a purchase 
is gradually diffused throughout all classes in society. 
From the hands of the retailer it is passed successively, 
perhaps, into the hands of the wholesaler, wage-earner, 
and landowner. It thus helps to determine the intensity 
of the money demand of consumers for the goods. 

But even if the effect of this advance of credit upon 
supply and demand conditions elsewhere is ignored, it is 
clear that the price our dealer will pay will be influenced 
by his knowledge of the bank's attitude toward his re- 
quests for credit. In making credit available for the dealer, 
the bank exerted an influence upon the money demand for 
the goods. 

The writer does not mean to argue that there are no 
limitations upon banks* ability to affect the price level by 
the liberality of their credit grants. Under certain con- 
ditions, particularly those of declining confidence in the 
future stability of the market, banks' discount policies 
may have little effect on market prices. Bank credit can- 
not be forced upon a reluctant business community. But 
in a situation of increasing business confidence and rising 
markets, of business activity and commodity speculation, 
such a situation in fact as that of the summer and fall of 
1919, banks did hold the key to the situation. They fur- 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 309 

nished the credits which enabled buyers to shove up prices 
in their eager desire to get goods quickly. 

As indicated in the previous chapter,^ however, an en- 
larged money demand does not always bear as its prin- 
cipal fruit higher prices. The enlarged money demand may 
enable the scale of production to be increased on terms of 
lower per-unit costs. To quote from the writer's statement 
j in another connection : * 

Suppose the situation is one in which additional labor and 
materials are easily available, that new orders need not necessi- 
tate enlargements of plants or changes in equipment. Larger 
production may create possibilities of economy in the amount 
of overhead or fixed charges allocated to each unit of output. 
If, under these circumstances, retailers are stimulated to a 
reasonable extent by information that the required credit will 
be forthcoming, prices are not necessarily disturbed. As a 
matter of fact they may even be lowered in that the retailers' 
orders may make possible production under conditions of greater 
efhciency. It may no longer be a matter of setting up greater 
dollar competition for the limited quantity of goods, but rather 
using more dollars to affect the transfer of more goods. Easy 
and abundant credit may thus affect either the level of prices 
or the volume of production or both. Undoubtedly the situa- 
tion in which prices and production are both affected outnum- 
ber the cases in which abundant credit works upon the one alone. 
But as to which is most influenced an a priori answer is not 
possible. It all depends on the industrial situation. 

It is unnecessary to present evidence regarding the 
nature of the industrial situation in the period following 
the spring of 19 19. It was a boom period of the most pro- 
nounced character. Little good unemployed labor was to 
be had, goods and materials could be acquired only by 
bidding against competitors who were also short in sup- 

» See supra, pp. 281, 282. 

' Cf. H. L. Reed, "A Stabilized Dollar," American Economic Review, March, 
1921, pp. 91-93. 



310 FEDERAL RESERVE POLICY 

plies, extra production could be had only by expensive 
enlargements of buildings and changes in machinery. 
Production could not be speeded up so rapidly as credits 
were increasing. Speculation, and not social production, 
absorbed a large portion of the volume of bank credit, and 
speculation tended to accelerate the rapidity of price 
advance. This was a situation in which bank credit 
played its part in increasing the buying competition and 
in diffusing throughout the business community the buy- 
ing power in terms of dollars, on the basis of which prices 
were fixed. 

Simple as is this principle, it is extremely difficult to 
secure assent to it by the general public. No matter what 
the industrial situation, restrictions of credit grants are 
always unpopular. It is always asserted that the banks 
are handicapping productive enterprise. It is not under- 
stood that when the productive engine is running at full 
speed more fuel will not aid it. It is not clear that credit 
granted to this enterprise in a boom period may not add 
to the total volume of production. It is forgotten that too 
great activity soon brings the inevitable reaction by en- 
couraging unsound enterprise. Money is confused with 
wealth, and the public's first reaction is always to side 
with the proponents of easy money. 

Expressive of the popular point of view the following 
quotation might be made from a letter of a New Jersey 
banker, E. C. Stokes, written in the summer of 1920, to 
Senator Owen, commending the latter on his protest at the 
Board's belated policy in raising its discount rates: ^ 

Increased credit is not the cause of high prices. Increased 

credit is the result of high prices and is necessary because 

prices are high. If the industries and business of the land could 

be assured of more and cheaper credit, production would be 

' See Commercial and Financial Chronicle, June 5, 1920, pp. 2344-45. 



DEVELOPMENT, NOV. 12, 1918, TO MAY, 1920 311 

encouraged, and with an increase of production prices would 
fall. With assurance of the proper amount of credit at reason- 
able rates, intensive production would follow and prices would 
be cheaper, even without a reduction in wages. This production 
however, will never be undertaken by the manufacturer or even 
by the farmer if he thinks his loans are going to be called or 
curtailed and he himself forced into bankruptcy because of 
inability to carry his enterprise to completion. 



There then follow illustrations of the very many projects 
which it would be desirable to encourage. Not a sentence 
in the entire letter displayed an inkling of an understand- 
ing of where the labor and materials for these vast new 
projects could be found. There was no recognition of the 
fact that unduly rapid credit grants at one period cannot 
accelerate continuously the speed of the industrial 
machine. All that was understood was that economic 
activity increases in the early periods of cheap and abun- 
dant credit. But price adjustment to new and higher 
levels makes the advantage of easy money only temporary. 
Only continued increases in bank advances enable the 
boom to go on. There has to be a stop sometime. It is 
desirable that the brake be put on before the situation has 
become ripe for a violent reaction. The industrial situa- 
tion must be contemplated from a long- as well as from a 
short-time point of view. 

It must be admitted, however, that such demands for 
unlimited credits as those just quoted from the letter of 
Mr. Stokes are the natural fruit of the price theory, for- 
mulated by the Governor of the Federal Reserve Board, 
that prices determine the volume of advances the banks 
must make. 

But this was not all. Reserve banks deal mainly 
with member banks, and there was much doubt as to the 
effect of rediscount rate increases upon the operations of 



312 FEDERAL RESERVE POLICY 

the latter. The spread between the prevailing commercial 
rate and the reserve rate appeared to be so great as to 
make rediscounting profitable despite moderate redis- 
count rate increases. These rate increases could only be 
moderate because of the Treasury's low-interest-bearing 
flotations. It is true that a higher rate could have been, 
and as a matter of fact was, decreed for non-war paper. 
But this meant merely that member banks offered war 
instead of commercial paper in their rediscount appli- 
cations. There was much doubt, moreover, as to how 
efficiently a rate increase would work. There was not 
sufficient past experience to guide the reserve adminis- 
tration in the formation of its discount policy. Expression 
was given to this difficulty by the following statement of 
the October, 19 19, Bulletin: ^ 

The extent to which Federal Reserve Bank rates may nor- 
mally be expected to be "effective," in the sense in which that 
term is used in Continental Europe, still remains to be deter- 
mined. Our experience under the Federal Reserve system is too 
brief to enable definite conclusions to be drawn with reference 
to this matter. It seems doubtful, however, whether, for a long 
time to come and taking the country as a whole, there will be 
any such close connection of Federal Reserve Bank rates with 
the volume of credit in use as was to be noted, for example, in 
pre-war days in England, the home of central banking. Our 
nearest approach to an effective Federal Reserve Bank rate 
was reached In the closing months of the year 19 16. 

This matter will be discussed more completely in the 
following chapter. But sufficient explanation should have 
been offered regarding the hesitation of the Board to insist 
upon higher rates in the early part of the industrial boom 
of 1919. 

The situation, however, soon became such as to demand 
restrictive measures. The loss of gold to foreign countries, 

» Page 911. 



DEVELOPMENT, NOV. 12, 1918. TO MAY, 1920 313 

together with the great increase of advances to member 
banks and note issues resulted in considerable worry re- 
garding the adequacy of the reserve ratio.' These facts 
are expressed by the following figures : 









Ratio of Cash R.e- 




Total Gold 


Total Net Deposits 


serves to Net De- 


Date 


Reserves of 


AND Federal Reserve 


posits AND Federal 




Reserve Banks 


Note Liabilities 


Reserve Note Lia- 
bilities 




000 


's Omitted 




1919 . 








June 6 


$2,201,804 


$4,225,155 


537 


Julys 


2,128,946 


4,324.351 


50.8 


August I 


2,088,475 


4,273,001 


50.5 


September 5 . . 


2,067,052 


4,235,814 


50.4 


Octobers 


2,135,282 


4,434,452 


497 


November 7 . . 


2,119,565 


4,677,269 


46.8 


December 26. . . 


2,078,432 


4,762,116 


44.8 



Meanwhile also the dates were approaching upon which 
member banks would no longer be obligated to carry the 
bond subscriber. Most banks had agreed to make one- 
year loans to subscribers for the Fourth Liberty Loan and 
six months* loans to purchasers of the Victory notes. 
According to such arrangements these loans would expire 
in October and November. Although the Treasury's short- 
term floating debt increased throughout the summer of 
19 19, it reached its peak on August 31, 19 19, and it be- 
came probable that the Treasury's requirements would no 
longer be so controlling a factor. As stated in the October 
I, 19 19, Bulletin:^ 

The disappearance of the Treasury from the long-term loan 
market and the rapid reduction in its requirements for short- 
term accommodations foreshadows the approach of the time 
when the financial operations of the Government will cease to 
be the important factor in shaping Reserve Bank policies which 
they have been, and Federal Reserve Bank rates once more 

^ From January i, 1919, to November 10, 1919 (the approximate date of the 
fate increases), the excess of gold exports over gold imports was $226,089,000. 
* Page 910. 



314 FEDERAL RESERVE POLICY 

will be fixed solely "with a view of accommodating commerce 
and business." 

By the fall of 19 19, moreover, it was becoming clear that 
new creations of currency and credits were no longer exert- 
ing a stimulating effect upon the country's productive 
activities. Much worry was occasioned also because of the 
undesirable quality of paper in member banks' portfolios. 
In particular, the percentage of renewals was far too large. 
What theory had predicted confidently at an earlier date 
was now being exemplified by results. The country's pro- 
ductive mechanism could not accommodate too big a load. 
In the early part of November, accordingly, rates were 
increased slightly at all reserve banks as a means of 
indicating the determination to raise rates still higher if 
the reserve ratio fell further. On December 11, after 
the autumnal demand for funds had subsided, another 
slight rate increase was sanctioned by the Board. 

The reluctance of the reserve administration to adopt 
these measures is evidenced by the fact that the increase 
was preceded by many warnings. For instance, on June 
10, 19 19, the Board made public the following letter which 
had been sent out to all Federal Reserve agents : ' 

The Federal Reserve Board is concerned over the existing 
tendency toward excessive speculation, and while ordinarily 
this could be corrected by an advance in discount rates at the 
Federal Reserve Banks, it is not practicable to apply this check 
because of Government financing. By far the larger part of the 
invested assets of Federal Reserve banks consists of paper 
secured by Government obligations, and the Board is anxious 
to get some information on which it can form an estimate as to 
the extent of member bank borrowings on Government collat- 
eral made for purposes other than for carrying customers who 
have purchased Liberty bonds on account, or other than for 
purely commercial purposes. 

» Cf. BuUetin, December i, 19 19, p. 1108. 



DEVELOPMENT,.NOV. 12, 1918, TO MAY, 1920 315 

The rate increases of 19 19 were continued in the early 
months of 1920. In January, after the Treasury had 
raised the rate on short-term certificates to 4^ per cent, 
the Board approved a similar increase on paper secured by 
these certificates. 

Toward the end of January, however, the rate on paper se- 
cured by Liberty bonds and Victory notes was advanced to 
5>^ per cent and the rates on all classes of commercial paper, 
including trade acceptances and agricultural and live-stock 
paper, to 6 per cent.* 

Except in the financial centers of the country these 
increased rates had little real effect in checking the con- 
tinuous expansion of credits. By the end of April, 1920, 
the total earning assets of reserve banks were considerably 
larger than in December, 1919. But it had become evident 
that the rate of credit and currency increase was falling 
and that the speculative boom was collapsing. With the 
spring of 1920, one stage in the post-war business cycle 
was drawing to a close. 
• Report of the Federal Reserve Board, 1920, p. 57, 



CHAPTER XVI 

FEDERAL RESERVE DEVELOPMENT, MAY, 1920, TO 

THE PRESENT TIME 

THE PERIOD OF BUSINESS READJUSTMENT 

It is no part of the writer's purpose to measure statistically 
the relative influence of the various factors which cooper- 
ated to create the industrial reaction of 1920-21. Such a 
task would far exceed the limits of the present chapter. It 
will suffice for our plans to indicate the instability of the 
industrial situation in the spring of 1920 and to state 
briefly the causes of the subsequent depression. 

In the opinion of many the post-war boom had carried 
us to a new and permanently higher level of prices. A very 
large part of the world's total gold supply had come to the 
United States, and this gold, in large measure deposited 
in the vaults of the Federal Reserve banks, had furnished 
the basis for the creation of a much larger volume of 
deposits and note issues than the country ever before had 
witnessed. Relatively to commodities the media of ex- 
change had been greatly increased. The international 
trade situation, moreover, was not such as to indicate any 
early redistribution of our gold among the nations of 
Europe. Consequently, a larger volume of bank deposit 
and note currency could be supported without endanger- 
ing in the immediate future the maintenance of the gold 
standard. There were no indications, furthermore, that 
our banking administration would endeavor to deflate for 
the purpose of restoring the old price level. All the evi- 
dence pointed toward the acceptance of the belief that 
attempts to correct financial maladjustments should 



DEVELOPMENT, MAY, 1920, TO PRESENT 317 

assume the form of such devices as wage advances and 
railway rate increases. The rises in rediscount rates of the 
preceding period clearly had been initiated only as a means 
of preserving the reserve ratio and of preventing the inclu- 
sion in bank portfolios of too large a quantity of unsound 
paper. 

Nevertheless, the memories of a lower price level were 
still vivid to a large portion of the people. It is true there 
had been no indication of a sudden return to the 19 13 
level. But any temporary decline in the market would be 
interpreted generally as the beginning of the process of 
reestablishing ^*normaUty*' in prices. In this situation a 
voluntary lowering of prices to relieve congestion in the 
warehouses or on the shelves of merchants might not have 
the effect of increasing buying suddenly. If this viewpoint 
should be adopted generally, orders might be cancelled in 
large volume, the demand for labor lessened, and the re- 
duction in money wages restrict the ability of the public 
to purchase goods. All that was required to set in motion 
a continuously accelerating buyers' strike was evidence of 
temporary weakness in the market. 

The unhealthiness of the situation was due also to the 
fapidity of the price advance. All the weaknesses which 
normally develop in a period of- prosperity had been accen- 
tuated by the amazing speed in the upward movement of 
the market. Commodity and security speculation had 
been overdone grossly ; labor was losing its discipline ; the 
assumption of unwise ventures had been encouraged by 
artificial cheapness of money; bank reserves were falling 
rapidly. On the New York Stock Exchange the shares 
traded in during 19 19 were almost fourfold as great as in 
19 13, and bond activity was multiplied almost sevenfold. 
Total bank clearings for the Nation were approximately 
two and a half times as great in 19 19 as in 19 13. The 



3i8 FEDERAL RESERVE POLICY 

Comptroller's reports showed that net deposits of national 
banks had increased from 7. i billions of dollars on October 
21, 1913, to 12.2 billions on September 12, 1919. 

It is inevitable in such eras that values and operations 
become based not solely upon confidence that former 
growth will be maintained, but that the rate of accelera- 
tion will be continued. Present speculation rests upon 
future anticipations. But by the spring of 1920 it was 
evident that, while the limit of their resources had not been 
reached, banks were genuinely worried as to their ability 
to finance new projects. The maturities of paper were 
growing and the percentage of renewals increasing. Con- 
siderations of public finance pointed also toward higher 
rates in the near future. In 1920 the Treasury advanced 
the rates on six months' certificates to 5J^ per cent and to 
6 per cent for twelve months' maturities. The Treasury 
was no longer to dominate the reserve banks so completely 
in the formation of discount policies. The money market 
was no longer to be kept so low by artificial measures. The 
true rate of interest was to be permitted to emerge. Coin- 
cidentally with the rise in rates the member banks were 
being cautioned against the granting of unessential credits. 
Further credit expansion was possible, but the rate of past 
growth must fall. 

Had the physical volume of production been less large 
in 19 19 and 1920 the date of the reaction might have been 
postponed. But the volume of production, particularly in 
the first half of 1920, was enormous. The Government's 
crop forecasts for 1920 were exceedingly favorable, presag- 
ing one of the best years on record. Mills and factories 
were thought generally to be working close to maximum 
capacity. But railroads found themselves unequal to the 
strain thrown upon them. The reports of the American 
Railroad Association disclosed a net shortage of cars three 



DEVELOPMENT, MAY, 1920, TO PRESENT 319 

of the last four months of 19 19 and for every month of the 
first half-year of 1920. Shipments which might have been 
dispatched on advantageous terms were delayed until an 
enormous quantity of goods accumulated in the centers of 
production. It required not much of a shock to induce a 
general order of price cutting in order to move goods. 

It had been apparent for some time that the inter- 
national trade situation was growing more and more un- 
healthy. The balance of trade for 19 19 was over four 
billions of dollars in our favor, exceeding all past records. 
But in each of the first four months in 1920 the balance in 
our favor was much less than that for 19 19. In several 
markets 1920 was to witness a sharp price break. After the 
early collapse of the silk market in Japan, there were rapid 
declines in the prices of sugar, coffee, and other products 
of Cuba and Latin-American countries. The Federal 
Reserve Board's international wholesale price index 
showed a price decline^ in April for Japan, and a May de- 
cline for the United Kingdom, France, Italy, and Japan. 
In June, 1920, the Bureau of Labor Statistics' index num- 
ber for wholesale prices of all commodities in the United 
States was to show the first recession experienced since the 
early part of 19 19. The accumulation of goods created 
by the inability of the railroads to furnish sufficient cars 
and the crash in foreign markets may have been the imme- 
diate factors causing the first severe shock to business con- 
I fidence. Once this check had been felt, it was impossible 
1 to prevent the manifestation of all the weaknesses in the 
industrial system which have been developing gradually 
in the preceding boom period. The buyers' strike became 
soon, not a matter of volition, but of downright necessity. 
The reduction in money incomes created less demand for 
labor's services. 
» See Report of the Federal Reserve Board for 1920, p. 7. 



320 



FEDERAL RESERVE POLICY 



A krge part of the Federal Reserve administration's 
policy during the crisis may be told statistically. The 
following figures depict the situation regarding changes in 
the reserve ratio, note issues, member banks' reserve 
account, total earning assets, and rates of discount on 
ninety-day paper. 



Date 



1920 

May 7 . 
June 4 . 
July 2 . . 
Aug. 6 . 
Sept. 3. 
Oct. I.. 
Nov. 5 . 
Dec. 3 . 



192 1 
Jan. 7.., 
Feb. 4. . . 
March 4. 
April I . . 
May 4 . . 
June I . . 
July 6... 
Aug. 3 . . 
Sept. 7.. 
Oct. 5... 
Nov. 2 . . 
Dec. 28 . 



Total 
Earning 
Assets 



Federai- 
Reserve 
Notes in 
Circula- 
tion 



In billions of dollars 



3.21 

3-27 
3.27 
3.18 
3-36 
3.30 
3-42 
3-33 



3.13 

2.88 
2.78 
2.61 
2.42 
2.26 
2.09 
1.90 

1.79 
1.66 

1-54 
1-53 



3-09 
3.12 
3.16 
3-14 
3-24 
3-30 
3-35 
.3.31 



3-27 
3-07 
3.04 
2.90 

2.82 

2.75 
2.67 

2.53 
2.51 

2.48 
2.40 
2.44 



M 

Banks' 
Reserve 
Account 



1.79 

1.74 
1.70 
1.67 
1.67 
1-65 
1.65 
1.61 
1.63 
1. 61 
1.65 
1.66 



Cash 

Reserve 
Ratio 



Discount 
Rate on 
90-Day 

Paper in 
Effect 

First Day 

OF THE 

Month 1 



Discount 

Rate on 

90-Dav 

Paper 

Secur-ed by 

Liberty 

Bond and 
Victory 

Notes thb 

First Day 

OF THE 

Month I 



In percentage 



42.7% 




6% 


42.5 


6.25 


42.8 


6.3 


44.0 


6.3 


42.5 


6.3 


43.7 


6.3 


43.0 


6.4 


44.1 


6.4 


46.4 


6.4 


49.3 


6.4 


50.8 


6.5 


52.4 


6.5 


55.3 


6.4 


574 


6.19 


60.0 


6.08 


637 


5-87 


66.2 


5.79 


69.0 


5-75 


71.0 


5.66 


71. 1 


5.04 



5.6% 

5.7 
5.76 

5-77 
5-77 
5.81 
5.81 
5.81 



5.81 
5.81 
5-95 
5.95 
5.95 
5.95 
5-95 
5.83 
5.74 
5.70 
5.66 
5.04 



Average for the twelve Districts. 



These facts show that there was no contraction of cur- 



DEVELOPMENT, MAY, 1920, TO PRESENT 321 

rency or credits enforced by Federal Reserve authority 
during the depression. The combined Federal Reserve 
note circulation and member banks' reserve account at 
the close of 1920 exceeded that of the spring of the year. It 
should be kept in mind that these advances were main- 
tained in volume despite the drop in prices. Since lower 
prices lessen the need for credits, the growth in reserve 
bank advances was in reality much larger than the figures 
indicate. The wholesale price index of the Bureau of Labor 
Statistics, which was 272 in May, 1920, had fallen to 189 
in December of the same year. So willing were the reserve 
authorities to employ their resources for the legitimate 
requirements of member banks that it was not until after 
the beginning of the new year that the reserve ratio began 
to move to a point commanding confidence. Discount 
rates increased until the spring of 192 1, but they were 
never unusually high relatively to market rates. As a 
matter of fact they followed rather than preceded the 
movement of money rates in the financial centers. Until 
the summer of 192 1 rates on four to six months' prime 
commercial paper were close to eight per cent in the New 
York market. 

Recovery from the crisis was slow and uncertain. Bond 
and stock prices began to move upward sharply in the 
early summer of 192 1. But security price movements 
precede usually the revival of business confidence. It was 
not until the close of 192 1 that the volume of new securi- 
ties issued became such as to indicate any general return 
of confidence. Nevertheless, at the close of the year statis- 
tics of failures portrayed greater mortality than at any 
preceding date of the crisis. 

The public was somewhat slow to perceive the extreme 
severity of the depression. Had there been no Federal 
Reserve system to prevent credit contraction, a financial 



322 FEDERAL RESERVE POLICY 

panic of unexampled dimensions might easily have 
occurred. What the reserve system has done has been to 
draw out the period during which Hquidation took place. 
But so far-reaching were the maladjustments which had 
developed in the preceding boom period that no sudden 
revival of confidence was possible. Too many prices got 
out of line with each other. Relatively to other prices, 
agricultural commodities fell too far. As a consequence 
the agricultural demand for manufactured products con- 
tinues low. Unless, furthermore, adequate machinery is 
developed for supplying Europe with production goods for 
restoration purposes, we cannot count on the foreign 
demand. Building, however, is rapidly developing into 
the dimensions of a boom, and in this lies the germ of 
speedy resumption of industrial activity. 

With the clearing of the industrial situation it is espe- 
cially desirable that Federal Reserve policy for the future 
be formulated more definitely. In all the eight years of 
Federal Reserve operation there has not been a period 
when the administration was free to make a comprehen- 
sive statement of the relation of the reserve banks to other 
parts of the financial mechanism. Until 19 17 the problem 
was that of acquainting member banks with the reserve 
banks' facilities and of getting into the market at a time 
when member banks* reserves were high. From 19 17 to 
the armistice the requirements of war or of war prepara- 
tion were dominant considerations. In the post-war ex- 
pansion period the Treasury's needs were such as to cause 
purely banking requirements to be subordinated. In the 
period of depression the inevitable charges of undue sever- 
ity made the situation inopportune for any clear state- 
ment of future discount policy. But in the coming period 
of industrial revival it is important that the essentials of 
rediscount control be developed. If this be not done, 



DEVELOPMENT, MAY, 1920, TO PRESENT 323 

industrial activity again may attain unhealthy dimensions 
thus breeding the forces of another reaction. The late 
depression has shown that, while the reserve system may 
serve to prevent sudden liquidation and thus to lessen the 
acuteness of the shock, it cannot prevent unhealthy 
tendencies from asserting themselves in the form of 
destroyed business confidence. 

At the present time the surplus reserves of the reserve 
banks are enormous. December 28, 192 1, the total re- 
serves of the reserve banks were 2992.2 millions of dollars. 
This would form a forty per cent reserve for 7480 millions 
of note issues and deposit credits granted to member 
banks. Assuming member banks require a fifteen per cent 
counter money and legal reserve combined, this 7480 mil- 
lions would enable them to advance 49,866 millions to the 
business public. Since the total net deposits of national 
banks on the Comptroller's report for September 6, 192 1, 
was 10.8 billions of dollars, an approximate fourfold expan- 
sion in national member banks' advances is possible. Here 
lie opportunities for inflation never before possessed in like 
measure by any banking system. If any large part of this 
new credit supply is utilized suddenly, the price level must 
react correspondingly. It is not possible that our physical 
volume of production be increased in any such meas- 
ure. Too rapid credit expansion must mean price inflation. 
It, therefore, is more essential now than ever before 
that definite principles of credit control be formulated. 
Day-to-day considerations cannot be permitted to gov- 
ern unless the reserve banks are to become mere engines 
of inflation. 

Until business confidence is restored there is no danger 
of unduly rapid creations of currency or credits. New 
issues would become redundant. But in the next era of 
business revival it will be necessary' to know when the 



324 FEDERAL RESERVE POLICY 

endeavor should be made by reserve banks to restrict 
credit increases. Let us consider accordingly the wisdom 
and practicability of the following bases of credit control : 

(a) Regard should be had primarily for the reserve 
ratios of reserve banks. In other words, reserve banks 
should take into account the same sort of considerations 
which guide the loan policies of member banks. They 
should concern themselves primarily with their ability to 
meet their obligations. 

(b) Credit advances of reserve banks should be regu- 
lated in such a manner as to maintain the price level as 
stable as possible. 

(c) Credit advances should be regulated in such a man- 
ner as to maintain the productive activities of the Nation 
as great as possible. Regard should be had, however, for 
long rather than for short-time considerations. 

(d) Since certain excesses, such as impaired liquidity, 
appear whenever industrial activity is fanned by excessive 
credit grants, restriction should be begun whenever these 
evils become more than ordinarily prominent. 

Let us consider these possibilities in turn. 

There appears to be much to ofFer for a policy of utiliz- 
ing the reserve ratio as a guide for rediscount policy. In 
Sprague's words : ^ 

It is definite and obvious. Public opinion may be expected 
to support the always unwelcome policy of credit restraint 
when that policy is enforced by a depleted reserve. It is un- 
happily very doubtful whether the public would have been 
reconciled to the advance in rates made last spring [1920] if 
the reserve banks had had, let us say, a reserve ratio of 55 
per cent, and yet, all other things being the same, an advance 
in rates would have been no less desirable. 



* Cf.O. M. W. Sprague, "The Discount Policy of the Federal Reserve Banks, ' 
American Economic Review, Marcli, 1921, pp. 27, 28. 



DEVELOPMENT, MAY, 1920, TO PRESENT 325 
Further: 

There is no substitute for the reserve ratio which possesses its 
pecuHar virtues of simplicity and definiteness. 

It is extremely unfortunate, therefore, that the situation 
frequently may develop to necessitate credit restriction 
even at a time when reserves are increasing. In a season 
of very active trade, payment of foreign balances might 
compel the shipment of gold to this country. In that 
situation our bank reserves would increase, yet the possi- 
bilities of too rapid expansion might then exist. The quan- 
tity of gold in the reserves is a product of more or less for- 
tuitous circumstance and bears no necessary relation to 
the credit requirements of business. 

There is also much to say for making price stability the 
test. The injustices of a rapidly changing price level are 
now recognized fully. Since bank credit is our most impor- 
tant medium of exchange, its volume should be regulated 
in such a way as to ensure a fair degree of price-stability 
over a course of time. It is also true that a chief evil created 
in a boom period is the throwing out of adjustment of 
various prices. The greater the rise in the general level, the 
greater the probability that their normal relationship will 
be disturbed. To maintain the level of prices stable, 
therefore, might accomplish much in the way of eliminat- 
ing periodic disturbances in business. 

It is doubtful, however, whether public opinion would 
ever sanction the use of such a guide. As indicated pre- 
viously, the people of this country lean innately toward 
the side of easy money. Particularly true is this of seasons 
of activity. The matter of legal authority for such a test 
is also doubtful. Mr. A. C. Miller, of the Federal Reserve 
Board, has stated:^ 

' "Federal Reserve Policy," American Economic Review, June, 1921, p. 193. 



326 FEDERAL RESERVE POLICY 

There is now no warrant in the statute under which the federal 
reserve banks are organized for undertaking to regulate their 
credit operations on any such basis. The economic logic of the 
Federal Reserve act is clearly predicated upon the theory that 
the federal reserve banks shall be operated with regard to re- 
serve ratios, and "rates be fixed with a view of accommodating 
commerce and business." It would imply a very latitudinarian 
construction of the term "accommodating commerce and 
business" for the Federal Reserve Board and the federal 
reserve banks^to adopt the "observed effects of credit on prices" 
as their rule of action in the future. There is not, however, the 
slightest reason for supposing that such a procedure on the part 
of the federal reserve banks would be viewed with public 
approval. Quite the contrary. Public sentiment in the United 
States is, and always has been, highly sensitive in matters of 
credit control, and precisely, among other reasons, because 
of the bearing that such control has, or is believed to have upon 
the movement of prices. 

Mr. Miller's efforts accordingly are designed to alter the 
reserve machinery in such a way as to make it more safe 
to depend upon the use of reserve ratios as a guide. 

Mr. R. C. Leffingwell's vigorous statement on this 
matter is as follows : ^ 

I share Dr. Miller's objection to Professor Sprague's sugges- 
tion that federal reserve rates should be determined by price 
movements. There is no man, or group of men, to whom the 
American people will, or should, accord the right to determine 
whether they shall be prosperous or miserable, whether thay 
shall have high prices or low prices, whether they shall have 
good times or bad times. The day Professor Sprague's sugges- 
tion is adopted by the Federal Reserve Board marks the end of 
the federal reserve system. It would be absurd for the Federal 
Reserve Board to ignore price movements as symptoms of the 
general situation, but it cannot base its discount policy upon 
them. 

Both Miller and Leffingwell admit that the reserve 

^ "The Discount Policy of the Federal Reserve Banks," American Economic 
Review March, 1921, p. 35. 



DEVELOPMENT, MAY, 1920, TO PRESENT 327 

ratio alone cannot be an adequate guide. But in order to 
enable it to be utilized with effectiveness, they make cer- 
tain proposals designed to remove the dangers connected 
with its use. Leffingwell suggests' that 

If the reserve gets big enough to be embarrassing, the best cure 
for the situation which will then arise is to pay out gold and 
gold certificates, and restore them to circulation. 

This would have the effect of reducing the reserve ratio to 
a more manageable point. In an opposite situation, one 
in which the reserve ratio is low, gold could be retained 
when paid in by member banks and Federal Reserve 
notes issued to meet the general currency requirements. 

Miller's suggestion is much more involved. He desires^ 
the Federal Reserve notes to become more similar to the 
issues of the Bank of England. If a larger gold reserve 
could be allocated for note issues, the reserve ratio for 
deposits could be made such as to render it safer to depend 
upon it. Calls by the public for more credits, calls which 
arise in time of rapid expansion, would reduce rapidly the 
reserve for deposits in such a way possibly as to justify 
efforts to restrict further advances. In this way the reserve 
ratio could be made a more workable guide. 

Dr. Miller's suggestion is so important as to justify, 
perhaps, a somewhat extended quotation from his re- 
marks. Speaking first of the administrative changes that 
need to be made he states: 

The main change in the published weekly statement of the 
federal reserve banks that would be necessary would be to 
report the specific note reserve, held by the Federal Reserve 
Agent, and the specific deposit reserve held by the bank. The 
existing practice of stating the reserve position theoretically 
in the form of a ratio derived from a comparison of total re- 

» "The Discount Policy of the Federal Reserve Banks," American Eah 
namic Review^ March, 192 1, p. 36. 
^Op.cU. 



328 FEDERAL RESERVE POLICY 

serves with combined note and deposit liabilities should be dis- 
continued, or, if continued, be given merely for purposes of 
theoretical comparison, by the federal reserve system, and a 
form of statement should be set up which would show the re- 
serves actually held against deposits and notes respectively and 
separately, as the law contemplates. 

The existing gold holding of the reserve banks should be re- 
apportioned between the deposit reserve and the note reserve. 
To the deposit reserve might be allocated an amount of reserve 
money equivalent, say, to 45 per cent of their deposit liabilities 
as of the date when the new form of accounting would become 
effective. To the note reserve should be allocated all the remain- 
ing reserve, and, as the law requires, be in the form of gold. 

The reserve thus allocated to the deposit reserve should be 
regarded as the working reserve of the banking or discount 
department of the federal reserve bank. The banks should be 
expected to conduct their discount operations on the basis of 
this reserve. Until conditions justified, the amount of this 
reserve should not be changed. Fresh accessions of gold re- 
ceived by the banking department should be transferred to the 
note reserve by way of substitution for other collateral held 
by the Federal Reserve Agent, or in exchange for federal 
reserve notes. Withdrawals of gold from federal reserve banks 
for foreign shipment should, for the present at least, be taken 
out of the note reserve by the presentation of federal reserve 
notes for redemption in gold or by the substitution of com- 
mercial collateral for gold in the security held by the Federal 
Reserve Agent. The deposit reserve held by the banking 
department would thus be fairly constant in amount; the note 
reserve, on the other hand, would be variable in amount, 
fluctuating mainly in accordance with changes in the inter- 
national flow of gold, increasing when an influx was in progress 
and decreasing when an outflow was in process. 

While the deposit reserve under the arrangement proposed 
above would be constant, the deposit reserve ratio would not be 
constant but would fluctuate. Any expansion of the loan 
account of the federal reserve banks would quickly reflect itself 
in the diminution of the reserve ratio below 45 per cent; any 
diminution of their loan account would quickly reflect itself in 
an increase of the reserve ratio above 45 per cent. In brief, 



J 



DEVELOPMENT, MAY, 1920, TO PRESENT 329 

fluctuations in the reserve ratio would reflect quickly and accu- 
rately changes in the volume of the reserve banks' discounts. . 
From time to time the situation of the reserve banks as a 
whole, and of the several reserve banks individually, should be 
reviewed in the light of current credit conditions and needs in 
order to determine whether any reapportionment of reserves 
should be made; whether, e. g., any given bank should enlarge 
its deposit reserve at the expense of its note reserve. The 
modus operandi for effecting such enlargement would be for 
the bank in question to substitute commercial paper for gold 
as for collateral security pledged with the Reserve Agent for 
notes issued to the bank, the gold thus released being covered 
into the deposit reserve. So far as the bank's reserve position 
was concerned, this would be tantamount to the transfer of a 
certain amount of gold from the note reserve to the deposit 
reserve in order to give the bank an enlarged basis of lending. 

Under this arrangement the reserve ratio would decline 
rapidly in an era of credit expansion. **It would be a 
faithful indicator of what was going on." It could be 
relied upon much more confidently than at present. At 
the same time, the public could anticipate with.much more 
certainty future credit policy. 

Adequate preparation, furthermore, would have been 
made for future outflows of gold to foreign countries. It 
seems impossible that the world's gold can continue per- 
manently to be apportioned as inequitably as at the pres- 
ent time. Future withdrawals will likely be of enormous 
volume. Under Dr. Miller's plan the gold for these with- 
drawals would be conserved in the note reserve instead 
of having become demobilized by forming the necessary 
reserve for enlarged credit advances. This matter of mak- 
ing provision for future gold withdrawals, furthermore, 
might be accepted by the public as justification for this 
proposed change much more readily than the desire to 
protect the system against future price inflation. 

Although these suggestions represent merely an attempt 



330 FEDERAL RESERVE POLICY 

to remodel the Federal Reserve system more closely on the 
pattern of the Bank of England, they appear to the writer 
to deserve credit as a constructive proposal of great merit. 
It is particularly fortunate that they were formulated by a 
member of the Board. 

But valuable as these suggestions may be, their adop- 
tion would not provide a complete solution. There would 
still remain the question as to just how great pressure 
should be exerted at any one time to keep the credit situa- 
tion under control. How close to the legal minimum could 
the deposit reserve be permitted to sink without endan- 
gering its eventual sufficiency? And what would be the 
reply of the reserve administration if it were argued that 
its policy had been to the economic detriment of the 
country and that the gold earmarked as the deposit 
reserve had been made either too large or too small. In the 
final analysis the test of economic results must be applied 
to the reserve administration's acts. Making the reserve 
ratio a more accurate indicator will not accomplish every- 
thing. 

The writer agrees with Miller and Leffingwell that there 
is no authority in the act for making price stability the test 
of discount policy. Neither would it comprise per se an 
infallible test from the standpoint of economic theory. 
High prices may be due to other causes than excessive 
issues of currency or credit. They may be due to physical 
causes of scarcity, scanty rainfall, depredations of insect 
pests, labor troubles, and a host of other factors. The 
remedy for such a situation would not be restricted credit. 
Rather, the difficulties due to such causes might demand 
extra advances from the banks. To enable the producers 
to avoid financial failure, it might be that the banks would 
be required to supply the funds necessary to meet current 
obligations. 



DEVELOPMENT, MAY, 1920, TO PRESENT 33T 

It has been mentioned previously that there are situa* 
tlons in which slightly rising prices exert a tonic effect upon 
industry. Such a situation might be that following a 
period of subnormal activity. Federal Reserve policy 
should be adapted so far as possible to the requirements of 
productive efficiency and not to those of price stability. 
Over a series of years the volume of credit grants should be 
such as would lead to the maximum amount of produc- 
tion. The final test of the discount policy must be what 
production indices show regarding the effects of previous 
credit grants. If the curve of production is rising, there is 
justification for continued liberality. If past increases in 
the volume of credit have not correlated with an approxi- 
mately corresponding enlargement of physical production, 
the situation, in the absence of other counteracting factors, 
calls for restrictive measures. To quote from a previous 
statement by the writer: * 

Increase in the volume of rediscounts should be permitted 
so long as the main effect Is to enlarge the volume of production 
and not to raise the level of prices. Decreases In rediscounts 
should be enforced when It appears that the volume of business 
and consequently the need for credit is declining. Over a long 
period of time Increases in rediscounts should be apportioned 
to the natural rate of growth In the productive capacities of the 
people. To express the matter In terms of the equation ol 
exchange (P = MF)^ M should be altered when its principal 
effect will be borne by T and not by P, 

It should not be difficult to educate the public to this 
point of view. In every review of the month the produc- 
tion achievements of the country should be stressed promi- 

» H. L. Reed, "The Work of the Federal Reserve Board," Journal of Political 
Economy, January, 192 1, p. 76. 

» In this equation, symbol P refers to the price level, M to the amount of 
money in actual circulation, V to the rapidity with which the average unit of 
money circulates, T the volume of trade for the period. 



332 FEDERAL RESERVE POLICY 

nently. Attention should be called to the amount of credit 
advances for previous months and the attempt made to 
analyze their effects. Many would soon get in the habit of 
justifying credit advances according to their effect upon 
industrial activity. It should be seen that in a period of 
iabor unemployment, of surplus stocks in the hands of 
producers and dealers, liberal bank loans may mean pri- 
marily the enlargement of production, the bringing on to 
the market of goods which otherwise would not be created. 
In an opposite situation, one of full labor employment, of 
shortage in supplies and materials, the effect of credit 
advances should be higher money terms on which business 
men bid for the scanty supply of goods, materials, and 
labor. Expansion then must mean price inflation. 

In other words, the reserve bank which increases its 
operations should be made to defend its action on the 
ground that more credits were required to unlock unused 
productive resources. The writer is aware that the de- 
tailed rules for such a policy would call for a large measure 
of fine discrimination and that controversy must arise 
continually in their application. Nevertheless, there must 
be a correct formulation of the relation of increasing bank 
credits to the level of prices and the volume of trade. No 
ideal solution is otherwise possible. 

It should not be difficult to find authority in the act for 
such a policy. The act states that rates should be fixed 
"with a view of accommodating commerce and industry." 
In so far as commerce and industry require the credits to 
function most efficiently, an attempt should be made to 
render them available. But if trade and production can- 
not be increased in approximately corresponding measure 
by use of a larger volume of credit, restrictive measures 
should be employed. It should be easy to secure assent to 
these principles by endeavoring. continuously to lead the 



DEVELOPMENT, MAY, 1920, TO PRESENT 333 

public to compare changes in the volume of production 
with those in the volume of credit and currency. 

Decisions regarding the justification for increasing 
credits should be influenced also by qualitative considera- 
tions. In every season of unduly rapid activity certain 
excesses appear. Commodity and security speculation 
exceed past records, borrowers demand repeated renewals 
and loans of greater maturity, the liquidity of paper in 
general is reduced. By means of statistical comparisons 
with the usual or standard conditions, aid could be had 
in ascertaining whether there is justification for permitting 
the volume of reserve bank advances to be enlarged. 

At the present time there is a wide demand that as a 
permanent solution reserve banks' rates should be kept 
above the market rates. The argument is that the reserve 
banks should not contribute permanently any large part 
of the country's credit supply. The reserve banks* funds 
should be drawn upon only to meet extraordinary yearly 
or seasonal requirements. It is insisted that they should 
keep out of the market except in such situations. When a 
member bank rediscounts with a reserve bank, it should 
do so only at a sacrifice. This, we are informed, is an 
accepted principle of central banking procedure. ''Since 
187 1," for instance, "there has not been a single year 
when the official bank rate of the Bank of England was 
not above the market rate on yearly averages." ^ 

A serious difficulty with this proposal is that of deter- 
mining which of the various interest or discount rates 
should be taken as expressive of the general market rate. 
Should it be the rate on line-of -credit loans or should it be 
the rate on bank acceptances? Regarding this a Mil- 
waukee banker states: 

^ Cf. "The Gold and Rediscount Policy of the Federal Reserve Banks," by A. 
Barton Hepburn and Benjamin M. Anderson, Economic World, July 23, 1921, 
p. 112. 



334 FEDERAL RESERVE POLICY 

The volume of line-of -credit loans in this country is far larger 
than the volume of bank acceptance credits, but it may be 
doubted whether the rates on such loans are as competitive as 
bank acceptance rates. Bank acceptance rates are fixed in the 
open market and are published. Line-of -credit loans are not 
as competitive as they may seem. A small firm commonly 
maintains a line of credit only at its own bank. Large corpora- 
tions usually have lines of credit not only with their home banks 
but with large banks in financial centers, not necessarily because 
they can secure lower rates, but because no one bank wants to 
take care of their full needs. For these reasons it is to be doubted 
whether line-of-credit loans afford as good an index of money 
market tendencies as the bank acceptance rates.* 

Although the acceptance rate may represent best the 
drift of the market, it might not be practicable to rely 
upon it. In many situations line-of-credit rates are far 
above the more competitive acceptance rate. A Federal 
Reserve rate based upon the acceptance rate might not have 
the anticipated effect of keeping the reserve banks out of 
the market except in emergency conditions. A reserve rate 
based upon line-of-credit rates, on the other hand, might 
remain too uniform instead of displaying the proper degree 
of flexibility. 

It is believed, therefore, that no conscious effort should 
be exerted to make this the fundamental consideration. A 
rate fixed on the basis of preserving a reserve ratio, ren- 
dered manageable by the adoption of some such plan as 
Miller's, and modified according to production indices, 
ordinarily would be above the bank-acceptance rate. But 
as to how high above this rate it should be, this proposal ^ 
gives no information. A reserve rate kept above all bank 
rates in all communities would, frequently at least, be too 
high to be workable. A reserve discount rate kept just 

» See W. P. G. Harding, "Principles Governing the Discount Rate," The 
Anmls, January, 1922, pp. 183-89. 

' The proposal that reserve rates be kept above the general market rate. 



DEVELOPMENT, MAY, 1920, TO PRESENT 335 

above the open market commercial paper rate might not 
be high enough to be effective. 

The preceding brief discussion is designed to throw some 
light upon the question as to when reserve bank advances 
should be restricted. Let us next endeavor to ascertain 
the means which should be employed to restrict credits on 
occasions of necessity. Shall principal reliance be placed 
on rate increases? Or, will it be necessary to insist on 
direct rejections of applications on the basis of the quality 
of the paper offered? Or, finally, must greatest measure of 
attention be devoted to reserve banks* open-market 
operations? 

There is much to be offered in behalf of reliance upon 
rate increases. It is the only means of restricting credit 
grants which does not subject the bank to charges of par- 
tiality. The general public undoubtedly has no adequate 
understanding of the pressure which is brought to bear 
upon the district directorates in such a period as that 
following the fall of 19 19. Nothing can create more bitter 
criticism than the feeling that the bank discriminates 
unjustly against some portion of its customers. Particularly 
true is all this of the Federal Reserve banks. Their resources 
depend upon the contributions of all their members. Each 
member bank accordingly feels it has a claim upon the 
resources of the reserve bank on occasions of need. It is a 
requirement of policy that rate increases be made before 
other measures are attempted. 

The efficiency of rate increases may be considered from 
two points of view. First, will a higher rate exacted by 
reserve banks be reflected in an increased loan rate by 
member banks? Secondly, will an increase in the general 
market rate discourage most largely desirable or undesir- 
able business activities? 

For a time a certain theory was current which, if true, 



336 FEDERAL RESERVE POLICY 

would have denied the effectiveness of the rate-increase 
method. Rediscounts create reserves for member banks. 
For every dollar of reserve money, member banks may 
loan six or seven or more dollars to their own customers. 
Since they receive interest on several dollars, must not 
the discount paid on the one dollar obtained from the 
reserve bank be a minor consideration? Any slight 
advance in rediscount rates would appear to be of little 
effect. To be really effective it would seem that the reserve 
banks' rates must be absurdly high, as, forinstance twenty 
or thirty per cent. From the standpoint of commanding 
political support such a rate would be impracticable. 

Answers to this puzzling question were several. Some 
argued that rate increases would be effective merely 
because most bankers had got into the habit of comparing 
the rates they receive on loans with the rate they paid on 
rediscounts. If the reserve bank rate was the higher, loans 
to customers would be reduced. It was held to be not so 
much a question of what bankers should think, but what 
they usually did think. 

More complete analysis, however, would have indicated 
that there was little or no profit in paying a higher dis- 
count rate than that at which the funds were loaned. As a 
matter of fact banks cannot loan anything like six or seven 
or eight times the amount of credit obtained by the redis- 
count ing operation. Inter-bank relationships render this 
impossible. 

Suppose, for instance, a bank rediscounts sufficient 
paper to obtain a deposit credit of one dollar with a 
reserve bank. This one dollar of reserve money would 
enable the member bank to loan its customers, let us say 
ten dollars of deposit credits. In a short time, however, 
checks would be written against these deposits, and many 
of them deposited with other banks. In this way the other 



DEVELOPMENT. MAY, 1920, TO PRESENT 337 

banks would receive the right to demand cash from the 
original bank. To meet these demands our bank would be 
obliged to give up cash or engage in further rediscounting. 
It must figure, therefore, if its reserve was insufficient 
originally, upon rediscounting almost as many dollars as it 
loaned its customers. Because of this fact, banks would 
lose if they paid a rediscount charge very much greater than 
that received on their own loans. 

It might be argued that the loss of cash to other banks 
need not occur if other banks were expanding their loans 
as rapidly as the bank we have in mind. Our bank would 
be receiving as many dollars of checks drawn upon other 
banks as they would receive against it. But if this were 
the situation, the loans of our bank prevent it from gaining 
cash through a favorable clearing house balance. Cash it 
might have gained in this way, upon being deposited with 
a reserve bank, would enable it to loan several fold its 
amount. The rediscount finally necessitated the cutting 
down of its loans to an approximately equal amount. 
Bankers were correct in refusing to admit profits unless 
they receive from their own customers approximately the 
same rate they pay to the reserve bank.^ 

A second objection to the efficacy of rate increases is 
based upon the fact that many loans are exceedingly high, 
due to the fact that they are not subject to a high degree 
of competition. Many borrowers are unable to offer their 
paper outside their own community. In such situations 
the rates charged may represent some degree of monopo- 
listic extortion. It is well known that in many newly 
developing sections of the South and West it is customary 
for banks to exact a charge of ten, twelve, fourteen per 
cent. As a matter of fact there may be some justification 

' For a more elaborate discussion of this matter see Chester A. Philh'ps, 
Bank Credit, pp. 1-76. 



338 FEDERAL RESERVE POLICY 

for such high rates. The volume of business done in such 
communities may be so limited as to necessitate the alloca- 
tion of higher overhead charges to each dollar loaned. But, 
in such non-competitive situations, it would seem that an 
advance of a half per cent or so in rediscount rates might 
be a negligible consideration. 

There is much to offer on the other side, however. It is 
questionable the extent to which the abuses of over-rapid 
credit expansion arise in such communities. Commodity 
and security speculation, the securing of capital for new 
industrial enterprises, in general the activities at the basis 
of a boom, are financed much more largely by funds 
obtained from banks in the larger cities where competitive 
conditions do prevail. With money dear in these places, 
unduly rapid industrial activity might be discouraged to a 
greater or less degree regardless of what takes place in the 
smaller localities. 

By the application of the principle of progressive rates, 
moreover, banks even in these non-competitive communi- 
ties might be made to feel the effect of the reserve bank's 
rate increase. Authority for the establishment of a pro- 
gressive rate schedule has existed since the Phelan Bill 
became law on April 13, 1920. According to the terms of 
this bill rediscount rates may be increased for those mem- 
ber banks whose rediscounts exceed a specified base line to 
which the normal rate applies. During the latter part ol 
1920 effective use was made of this plan in two districts. 
In some cases member banks* applications were made as 
high as nine per cent for a portion of their borrowings. 

The progressive-rate plan has not been highly popular, 
and during the period of its application there was a more 
or less general demand for its abolition. Some such meas- 
ure, however, seems necessary if rate increases are to be 
made effective in communities where strong competition 



DEVELOPMENT, MAY, 1920, TO PRESENT 339 

does not prevail. In situations demanding strict control of 
credit, inability to employ it may necessitate the use of 
other undesirable measures, such as the downright refusal 
to accept certain paper regardless of the amount of the dis- 
count that would be paid. 

Many of the doubts regarding the effectiveness of rate 
increases are based upon the experience of the system 
during the latter half of 1920 during which reserve ad- 
vances increased despite higher rates. But so over-ex- 
tended had most banks become in the preceding boom 
period that the process of liquidation was attended with 
great difficulty. There is general agreement that the rate 
increases of that year prevented the volume of advances 
from becoming as large as otherwise they would have been. 
It is not expected that many situations similar to those 
facing the reserve administration in the spring of 1920 will 
arise in the future. The credit and industrial situation at 
that time was intolerable. But it was due in large measure 
to the previous inability of the reserve banks to raise rates 
because of the Treasury's easy money programme. 

It may be that the effect of rate increases will be most 
largely sentimental; that they are effective only in so far 
as they give hint of the determination of the administra- 
tion to resort to stricter and more direct methods in the 
future. If this be true, it becomes necessary to develop 
standards for the application of methods designed to 
eliminate unessential paper. Such standards, however, 
should not be impossible of determination on the part of 
the district directorates. The former Director of the 
Division of Analysis and Research of the Federal Reserve 
Board has suggested that the proper test is that of liquid- 
ity. Restates:' 

* See H. Parker Willis, "Discrimination in Inflation," Commercial and Finari' 
cial Chronicle, September 11, 1920, pp. 1040-41. 



340 FEDERAL RESERVE POLICY 

If, for example, it should appear that a borrower had fallen 
into a way of business which required the extension of a longei 
and longer credit to customers, or that he was drawing upon 
securities of which he might stand possessed in order to protect, 
or collateral paper which he was keeping practically permanently 
in bank, or for which he was asking repeated renewals, the situ- 
ation would be such as to raise a strong presumption against the 
essentiality of his borrowing. 

But whatever the proper standards, they can be developed 
for use in situations where rate increases may not succeed 
in accomplishing their purpose. 

In a brilliant article in the American Economic Review^ 
Miss Anna Youngman argues that the warning effect of 
rate increases cannot be sufficient unless it is known that 
the reserve banks possess the power to break local rates 
which remain high in spite of the discount policy of the 
reserve bank. She insists that rate increases cannot be 
effective if the local banks previously have been exacting 
much higher charges than those of the reserve banks. In 
such situations the warnings of the reserve banks will be 
ignored. Accordingly she advocates the extension of the 
open-market powers of the reserve banks to include the 
promissory note as well as the bill of exchange. If reserve 
banks were empowered to deal directly in the prevailing 
type of paper, they would be in a position to keep rates so 
closely in touch with those of the reserve banks that 
advances in the latter should prove more effective. 

As mentioned previously, however, such a course would 

be politically hazardous. Nothing creates a greater degree 

of animosity toward the reserve system than the feeling 

that the district banks are competing with the member 

banks by using funds contributed by the latter. The 

weapons of the reserve system to-day are not perfect. But 

^ Issue of September, 192 1, pp. 466-85. "The Efficacy of Changes in the Rates 
of the Federal Reserve Banks." 



DEVELOPMENT, MAY, 1920, TO PRESENT 341 

it is believed they will be more powerful in ordinary situa- 
tions than it is generally felt. As reiterated often, the 
reserve banks could exercise no real control over the loan 
market in the post-war boom period. Requirements of 
Government finance were then the dominant considera- 
tions. Rather than increase the reserve banks' power to 
compete at all times more largely with member banks, it 
may be more expedient for the present to grant them 
further weapons in the use of their discount facilities. It 
may be preferable to permit them to "enforce reasonable 
regulations regarding usury or to refuse rediscounts to a 
bank that lends at extortionate rates. "^ 

The preceding discussion has emphasized the fact that 
an important question is the extent to which increases in 
reserve bank rates could be passed on to the business 
public. To what degree would higher rates discourage the 
public's demand for loans? It has been argued frequently 
that American business is commonly conducted on the 
basis of such liberal margins above cost that higher rates 
might not have the effect of limiting seriously the demand 
for credit. In the final analysis, however, all this would be 
a concern merely of the member banks. Member banks 
in the same manner as reserve banks desire to avoid direct 
refusals of loan operations. They would first proceed very 
likely on the basis of rate increases. But if the rate in- 
creases did not lessen the demand for loans, direct meth- 
ods, however unpopular, must be employed. This, how- 
ever, would not be a responsibility of the reserve banks. It 
would be a problem solely for the member banks. 

It may be true that rate increases would not be ideal in 
that they do not distinguish between socially desirable 
and socially undesirable demands for credit. Rate in- 
creases would impose the same handicap upon all regard- 

* American Economic Review, September, 1921, p. 478. 



342 FEDERAL RESERVE POLICY 

less of the quality of the economic service rendered by the 
borrower. It may be true that higher rates can be with- 
stood more easily by the borrower whose services are the 
least necessary to society. The margin of "profit may be 
greater in the field of commodity speculation or in the sale 
of adulterated goods. But it is impossible for the reserve 
management to attempt to distinguish between the legiti- 
macy of the various demands for credit. This, to repeat, 
is a problem primarily for the member bank. 

It is not believed, therefore, that the time is ripe to 
grant further weapons to the reserve banks. What is most 
necessary now is that some means be found which will 
relieve the reserve banks from undue pressure to grant in 
the next boom period all the credits their present huge 
reserves would render possible. Two things in the writer's 
opinion need now to be emphasized. First, the reserve 
ratio should be made more manageable by transferring to 
the note reserves all reserve money except that which 
forms a workable basis for advances to member banks. 
Secondly, no opportunity should be overlooked to con- 
vince the public that an increase in the credit volume is 
defensible only when it is necessary to give full play to the 
country's productive powers. The effect of credit upon 
production should be most closely observed. Production 
indices should be given a position of prominence in every 
issue of the Bulletin. 

The reserve system has been well managed. Although 
its policy has been developed in the stormiest years of 
American financial history, concessions have not been 
made destructive of its power and influence. Despite 
present attacks there is no doubt but that it has come to 
command the respect of the thinking American public. 
Bitter critics should remember that there has not yet been 
a period in its existence when the general situation would 



DEVELOPMENT, MAY, 1920, TO PRESENT 343 

permit the formation of ideal policies for future credit 
control. The present, accordingly, is not the time to grant 
compromise to the advocates of easy money and cheap 
credit. The system must be fortified to meet the demands 
of the coming period of industrial revival. In that period 
will be tested the ability of the American people and of 
the reserve administration to adapt the powers of a won- 
derful financial mechanism to the requirements of present- 
day business and industry. 



THE END 



INDEX 



Acceptance, trade, development of, 
105-27; bank, development of, 
154-84; foreign-trade and domes- 
tic-trade, 169-71, 194, 195. See 
Bank, Trade. 

Adams, L. R., quoted on deducting 
exchange, 37, 38. 

Advances, of reserve banks, redis- 
counts, 70-96; direct collateral, to 
member banks, 97-104; note is- 
sues, 205-20; of reserve bank 
deposits and reserves, 221-38. See 
Deposits, Note issues, Redis- 
counts, Reserves. 

Agricultural credit, characteristics of, 
128, 130, 132; restrictions on loans 
on real estate, 128-30, 133, 134; 
need of commercial bank for farm- 
ers, 131, 132; provisions in Reserve 
Act relative to, 134-37. 

Agricultural paper, eligibility of, 137- 
42; identification of, 142, 143; six- 

! months, rate of discount on, 146, 

147. 
Agriculture, legitimate needs of, 

not neglected, 148-50; extent of 

hostility encountered by, 148. See 

Farmers. 
Aldrich Bill, the, 2. 
Aldrich-Vreeland Act, the, 221, 222, 

242. 
American Acceptance Council, 123. 
Anderson, B. M., quoted on proba- 
bility of decline in prices, 295. 
Arbuthnot, Professor C. C, quoted 

on banking resources, 74. 
Asset currency, attempts to secure, 

205-08, 221. 
Atlanta Reserve Bank, and Supreme 

Court decision concerning cashing 

of checks, 36-38. 



Balances, minimum, 46. 

Baltimore plan, the, 221. 

Bank acceptances, essential function 
of, 154; in import trade, 155, 156; 
in export trade, 156-58; advan- 
tages of, 158-60; types of trans- 
actions in which it is permitted, 
160, 162; restrictions on use of, 
161-65; conditions governing use 
for permitted purposes, 165-69; 
foreign and domestic trade, iden- 
tification of, 169-71; classes of 
domestic, permitted, 171-73; re- 
strictions governing power of re- 
serve banks to accept, 173-75; 
syndicate acceptance, 175-80; 
policy in encouragement of use of, 
180-82; decline in, 182, 183; future 
development of, 183, 184. 

Bank notes, issuing of, confined to 
reserve banks, 209; bond-secured, 
211, 212; cause of increased cir- 
culation of, 212-14; Federal Re- 
serve, and Federal Reserve notes, 
213, 214; issuance of, under Al- 
drich-Vreeland Act, 242, 243. 

Bankers' acceptances, 191. 

Bankers' bank, 1-3, 105, 106. 

Banking systems, of Europe and 
America, 107. 

Banks, germ of, in note issues and 
deposits, 205. 

Barron, C. W., quoted on distribu- 
tion of funds, 246. 

"Based on live stock," ruling of 
Board on, 137. 

Bills of exchange, before the Civil 
War, 107; advantages urged in 
behalf of encouraging use of, i ii- 
14; an open-market paper, 191. 

Bonds, and bank notes, of national 



346 



INDEX 



banks, 209-12; involve present 
burden, 288, 289; prices of, 301- 

03. 
Book credits, 225, 237. 
" Buy-a-Bale-of -Cotton " movement, 

242. 

Cable Transfers, 195. 

Capital, definition of, 85, 86. 

Cash reserves, ratio of, to net de- 
posits and Federal Reserve notes, 
276. 

Central bank, fears of, 2; emergency 
character of, 6; arguments for and 
against, 105, 106; question of 
necessity of, 125; and bank note 
issues, 209. ' •= 

Checks, collections and clearances of, 
importance of, 20; indicate need 
of continuous operation of reserve 
banks, 20; difficulties of, prior to 
19 14, 21-25; indirect routing of, 
22-24; exchange exactions, 25-28; 
provisions of act dealing with 
collections and clearances of, 28, 
29; means of absorption of charges, 
29, 30; methods of collecting and 
clearing, at first various, 30; volun- 
tary-reciprocal plan of clearances, 
31, 32; new system of clearances 
beginning operations July 15, 1916, 
33 ; attempts at coercion in connec- 
tion with new system, 34-36; Su- 
preme Court decision concerning 
method of cashing, 36-39; the 
Hardwick Amendment, 40, 41; 
attitude of banks toward Board's 
clearance plan, 41, 42; conclusions 
regarding par collections contro- 
versy, 45-49; extent of use of, 207. 

Circulating medium, demand for, 
208. 

City banks and country banks, ex- 
change exactions, 25-28, 45-49. 

Clearances, check. See Checks, 
Collections. 

Clearing house certificates, 243. 

Clearing house functions, and Fed- 
eral Reserve Board, 28, 29. 



Clearing houses and clearing systems, 
before 19 14, 20. 

Collateral loans, 100-04. 

Collections, check, difficulties of, 
prior to 1914, 21-25; provisions 
dealing with, 28, 29; voluntary- 
reciprocal plan of, 31, 32; new 
system of, 33; attitude of banks 
toward Board's plan of, 41, 42; 
extension of system to time items, 
44, 45; conclusions regarding par 
collections controversy, 45-49. 

Commercial bank, the farmer's need 
of, 131, 132. 

Commercial paper, definition, 85, 86. 

Commodities, prices of, 278, 298. 
See Prices. 

Commodity rate, 143-46. 

Contract for sale, 87, 88. 

Cooperative credit institutions, 131, 
132. 

Cotton, at time of Great War, 241, 
242. 

Cotton loan fund, 242. 

Country banks and city banks, ex- 
change exactions, 25-28, 45-49. 

Credit, regional system susceptible 
to expansion of, 5, 6; principles of 
control needed, 19; agricultural, 
under the Federal Reserve, 128- 
53; two forms of, note issues and 
deposits, 205; way open for ex- 
pansion of, by amendment of June 
21, 19 1 7, 237; bank, on November 
23, 1917, 271-73; delayed process 
of war mobilization, 285; period of 
post-war expansion of, 292-315; 
and prices, as bearing on Reserve 
policy, 299-311; and production 
314, 342; bases of control of, 323- 
35; means of restricting, 335; and 
rate increases, 335-41. 

Credits, book, 225, 237. 

Currency, volume of, relation to 
price level, 306. 

Dairy cattle paper, 141, 142. 
Delano, F. A., quoted on purpose of 
reserve system, 248, 252. 



INDEX 



347 



"Department store" banking, 68. 
Deposits, a form of credit, 205; 
increase of importance of, 207; 
recognition of need of elasticity of, 
208; demand and time, 223, 224; 
with reserve banks, methods of 
establishing, 224, 225; net, the 
law's definition of, 238; effect of, 
on prices, 306, 307. 

Depreciation of the dollar, 200, 201. 

Discount, on ninety-day paper, rates 
of, 320. 

Discount operations, and open- 
market operations, comparative 
volume of, 1(^6; of newly estab- 
lished Federal Reserve banks, 245. 

Discount rates, acceptance and line- 
of-credit, 333-35. See Rates, 
Rediscounts. 

Discountable paper, regulations re- 
garding, 82-S5. 

'^Discounts, direct, not permissible at 
first, 97; reasons for discrimination 
against, 97-99; arguments for, ^ ; 
amendment permitting collateral 
loans, 100; use of direct collateral 
loan, loi, 102; advantages of di- 
rect loans, 102-04; in first years of 
the system, 253-57. 

District directorate, responsibility of, 
16, 17; and member banks, close- 
ness of contact of, 18. 

Dollar, depreciation of, 201, 202. 

Dollar exchange, 165, 166, 189, 203. 

Domestic-trade and foreign-trade ac- 
ceptances, 136, 169-71, 194, 195. 

Double name and single-name paper, 
75-82, 107-11. 

Draft, in slow accounts, 109; trade 
acceptance in form of, 115, 116; 
statusof, for goods to be used, 121; 
can be peddled, 136; for foreign 
trade, 166-69. 

Draining and tilling, notes for, 140, 
141. 

Earning assets, 320. 
Edge Act, 177, 178, 180. 
Elliott, M. C, quoted, 122. 



Emergency relief, or continuous 
operation, question of, 245-49. 

European banking methods, and 
American, 107. 

Evans, Judge Beverly D., his opin- 
ion concerning collection of checks, 
38. 

Exchange exactions, 25-28; means 
of absorbing, 29, 30; Mississippi 
law concerning, 35, 36; effect of 
Supreme Court decision concerning 
cashmg of checks, 36-39; and 
Hardwick amendment, 40, 41; 
attitude of banks toward Board's 
plan, 41, 42; legal warrant for, 43, 
44; conclusions regarding, 45-49. 

Export trade, use of trade accept- 
ances in, 156-58. 

Farmers, discontent with reserve 
system, 151-53. See Agriculture, 
Agricultural. 

Federal Reserve Act, the Hardwick 
amendment, 40, 41 ; amendment of 
June 21, 1917, 66, 231-33, 237, 238, 
263, 277; amendment of Septem- 
ber 7, 1916, 100, 176, 230; provi- 
sions in, relative to agricultural 
credit, 134-37; permitting national 
banks to accept for domestic pur- 
poses, 195; amendment of Sep- 
tember 17, 1919, 176; amendment 
of December 24, 1919, 177; be- 
comes law, 240. "^ 

Federal Reserve bank notes and 
Federal Reserve notes. See Note 
issues, Notes. 

Federal Reserve Banks, emergency 
character of, 6, 7; begin operation, 
244, 245; questions of policy con- 
cerning, 245; for continuous oper- 
ation, 245-49; earnings for 1915 
and 1916, 257, 258; operations, 
compared with those of private 
institutions, 258. See Reserve 
Banks. 

Federal Reserve Board, and the 
question of regional responsibility, 
16, 17; and Federal Reserve Banks, 



348 



INDEX 



17, 18; and clearing house, 28, 29; 
regulations of, regarding discount- 
able paper, 82-85; appointment of 
members of, 240; cooperated with 
the Treasury during the War, 267- 
70; cooperation with the Treasury 
a proper proceeding, 289-91 ; credit 
system of, 299, 307. See Credit. 

Federal Reserve Clearing System, 
278 «. 

Federal Reserve System, district re- 
serve banks the most character- 
istic feature: of, i; the underlying 

, theory of, 2; general considera- 
tions concerning admission into, 
50-52 ; national banks and, 52 ; con- 
ditions of membership in, for State 
banks, 52, 53; reasons for unwill- 
ingness of State banks to join, 54- 
64; appeal for entrance of State 
Banks into, 65, 66; increased mem- 
bership of State banks in, 67; 
considerations on State bank 
membership, 67-69; periods of, 
239 ; not in operation at beginning 
of Great War, 243, 244; meant 
to operate continuously, 245-49; 
difficulties of getting into the 
market, 249-52; rate policy, 252, 
253; discounts in first years, 253- 
57; open-market purchases in 
1915 and 1916, 256, 257; state- 
ment of policy during first period, 
258-60; in the industrial depres- 
sion of 1920-21, 320-22; future 
policy of, 322, 331, 342, 343. 

"Float," 24, 25, 226. 

Foreign branches, of American banks, 
175, 176. 

Foreign-trade and domestic -trade 
acceptances, 169-71, 194, 195. 

Foreign Trade Financing Corpora- 
tion, 179. 

Gold, accumulating In reserve banks, 
227-30, 235-37; in reserve banks, 
efficiency of, 233, 234; inflow of, 
235; holdings of, increased, 237, 
264, 265, 275, 276. 



Gold Settlement Fund, relation of,- 

to inter-district shifting of funds, 
ion., 29; enlargement of functions 
of, 45; establishment of, 259; and 
inter-bank balances, 278 n. 
Government bonds, 190, 194, 250. 

Harding, Governor, quoted on duties 
of Federal Reserve Banks and 
Federal Reserve Board, 17, 18; 
his attitude toward the Board's 
clearance plan, 42; opposed to 
plan of Senator Owen, 203; on 
Federal Reserve control of banking 
situation, 261; on notes, 270; on 
currency-volume and price level, 
306. 

Holmes, George K., 37, 130. 

Implement paper, eligibility of, 138, 
139, 142. 

Import trade, use of trade accept- 
ances in, 155, 156. 

Industrial reaction of 1920-21, 316- 
22. 

Inflation, price, during the War, 
278-84; due to method of financ- 
ing the War, 284-91; after the 
War, 295-99. See Prices. 

Inter-district lending of funds, 9- 
14. 

Investment operations of reserve 
banks, in 1917 and 1918, 273, 274. 

Investment paper, objections to 
rediscount of, 72-75; criterion of, 
85-93; and open-market opera- 
tions, 190. 

Investment trust, 177. 

Irrigation, 191. 

Jones, Mr., of the Federal Reserve 
Board, 240. 

Kemmerer, Professor E. W., 130. 

Lefiingwell, R. C, quoted, on rates, 
301-03; on reserve ratio, 326, 327. 

Live-stock paper, 137, 138, 141, 
142. 



INDEX 



349 



Loans, collateral, 100-04; real 
estate, National and State, restric- 
tions on, 128, 130, 133, 134; effect 
of rates on, 341, 342. 

McAdoo, Secretary, quoted on en- 
trance of State banks into Federal 
Reserve System, 65. 

Member banks, and district direc- 
torates, 18; State banks, 50-69; 
advances to, in form of rediscounts, 
70-96; direct collateral advances 
to, 97-104; restrictions on their 
power to accept bank acceptances, 
167-73; and redemption of bank 
notes, 215-17; reserves of, 222- 
24; methods of establishing de- 
posits with reserve banks, 224, 
225; and book credits, 225; reserve 
percentages for, 225-27, 232, 238; 
legal reserves of, to be held entirely 
on deposit with reserve banks, 231, 
232, 263; and the question of 
capital stock subscriptions, 250-52 ; 
conditions of, in second period, 
265, 266; reserve account of, in 
1917 and 1918, 274; effect of War 
on operations of, 276, 277. 

Miller, A. C, quoted on wages and 
cost of living, 305; his plan of 
credit control, 325-30. 

Mississippi law, as regards exchange, 
35, 36. 

Mitchell, Professor Wesley C, 279. 

Mortimer, Frank C, quoted on re- 
turn of capital stock subscrip- 
tions, 250, 251. 

Moulton, Mr., quoted, 79. 

Municipal bonds, 194. 

Municipal warrants, 250. 

^ National banks, membership of, 52; 

*^ legislation broadening powers of, 

68; bonds and bank notes of, 209- 

12, 220, 

National Reserve Association, 2. 

Net deposits, the law's definition of, 

238. 
Note issues, a form of credit, 205; 



developed before deposits, 206; 
subject to strict regulations by 
National Banking Act, 206; elas- 
ticity of, 208; concentrated in 
hands of reserve banks, 209; of 
Federal Reserve notes, 214; method 
of, 214-16; effect of, on prices, 
306, 307. 

Notes, bank, issuing of, confined to 
reserve banks, 209; bond-secured, 
211, 212; cause of increased circu- 
lation of, 212-14; issued to replace 
standard silver dollars destroyed, 
213; issuance of, under Aldrich- 
Vreeland Act, 242, 243. 

Notes, farmers', 137-42. See Agri- 
cultural credit. 

Notes, Federal Reserve, Issuance of, 
by Act of 19 13, 214; receivable 
by member and reserve banks, 
215; lien behind, 215; issued 
through rediscounts, 215, 216; 
return of , 2 1 6, 2 1 7 ; interest charges 
on, 217; outstanding of, 218-20; 
most Important element in our 
general circulation, 220; made more 
acceptable by amendment of Sep- 
tember 7, 1916, 231; substitution 
of, for gold, 235; to be counted 
as part of vault reserves, 236; take 
place of legal tender, 237; changes 
in circulation of, for various dates, 
274, 320; gold cover for circulation 
of, 275; effect of, on prices, 306, 
307. 

Open book account system, 108. 

Open-market operations, and dis- 
count operations, difference be- 
tween, 185-87; extension of, to 
reserve banks, 185; reasons for 
inclusion of, in final bill, 187-89; 
on quoting forward discount rates, 
189, 190; classes of paper per- 
mitted in, 190, 191; as regards 
maturity of bankers' acceptances, 
192, 193; as regards dealings in 
cable transfers and gold coin and 
bullion, 193; as regards purchase of 



350 



INDEX 



acceptances, 194, 195; compara- 
tive volume of, 196; objections to, 
196-200; proposal for separate 
reserve bank, 200-04; during 1915 
and 1916, 256, 257. 

Organization Committee, 240. 

Owen, Senator, quoted on abdica- 
tion of Board, 16; his proposal for 
separate reserve bank, 200-04. 

Perrin, John, quoted on direct dis- 
counts, 98. 

Phelan Bill, 338. 

Pittman Act, 212-14. 

Prices, wholesale, rise of, in period 
1917-1918, 278-80; retail rise of, 
in period 1917-1918, 279, 280; 
relationship between media .of 
exchange and, 280-82; results of, 
282-84; due to method of financing 
the War, 284-91; after the War, 
295-99; relation of, to volume of 
currency, 306; factors determining, 
307; and bankcredits, 308-11; as 
affected by enlarged money de- 
mand, 309; in industrial reaction 
of, 1920-1921,316-22; stability of, 
as test for rediscount policy, 324, 

325, 330-32. 
Production, as guide to future Fed- 
eral Reserve policy, 331-33; and 
credit, 342. 

Rates, 5-7; commodity, 143-46; dis- 
count, quoting forward, 189, 190; 
policy of Board in regard to, 
marked by conservatism, 252, 
253; on commercial paper, in- 
creased, 263, 264; from May, 
1917, to November 11, 1918, 
268-70; rediscount, 303-05, 311- 
15; of discount on ninety-day 
paper, 320; of reserve banks, and 
market rates, 333; acceptance and 
line-of-credit, 333, 334; reliance 
on, as means of restricting credit 
(progressive rate plan), 335-41; 
effect of, on demand for loans, 
341. 342. 



Real estate loans, National and 
State restrictions on, 128, 130, 

133, 134- 

Reclamation districts, 191. 

Rediscounts, cooperative function of 
reserve banks, 70, 71; provisions 
regarding, 71, [72; of speculative 
and investment paper, objections 
to, 72-75 ; single-name and double- 
name paper, 75-82; regulations 
regarding discountable paper, 82- 
85 ; determination of eligible paper, 
85-93; the question of limitations, 
93-96; and direct discounts, 97, 98; 
rate of, on six-months agricultural 
paper, 146, 147; no great demand 
for, at first, 250; rates of, 303-05, 
3 1 i-i 5 ; control of, essentials should 
be developed, 322; policy, reserve 
ratio as guide for, 324, 325, 327- 
30; policy, price stability as test 
for, 324, 325, 330-32; increase in 
rates of, as means of restricting 
credits, 335-41. 

Reed, H. L., articles of, quoted, 286, 
287, 309, 331. 

Regional banks, system of twelve, 2. 

Regional responsibility, 16, 17. 

Regional system, surprising outcome 
of legislative planning, i; state- 
ment of objections made to, 3-5; 
consideration of objections to, 5- 
18; and credit expansion, 5, 6; and 
continuous functioning, 6, 7; and 
rates, 6, 7; and sectionalism, 8; and 
inter-district harmony, 9-14; and 
complaints of sectional partiality, 
14-16; and regional responsibility, 
16, 17; merits of, 18; most vulner- 
able point of, 18. 

Renewal trade draft, 122. 

Reserve account, of member banks, 
320. 

Reserve bank, proposal for separate, 
200-04. 

Reserve banks, and check collections 
and clearances, 20-49; advances 
of rediscounts, 70-96; condition 
governing the power of, to acquire 



INDEX 



351 



acceptances, 173-75; open-market 
operations of, 185-204; advances 
of, note issues, 205-20; advances 
of, deposits and reserves, 221-38; 
their bank credits with member 
banks, 225; reserve percentages 
for, 225; efficacy of gold in, 233, 
234; and the question of capital 
stock subscriptions, 250-52; re- 
serves of, 264; investment opera- 
tions of, 273, 274; earning assets 
of, 274; ratio of cash reserves to 
net deposits and Federal Reserve 
notes, 276; relation of, to other 
parts of system, should be for- 
mulated, 322; surplus reserves of, 
enormous, 323; rates of, 333-35- 
See Federal Reserve Banks. 

Reserve clearing system. See Checks. 

Reserve funds, used for speculative 
purposes, 15 n. 

Reserve percentages, 225-27, 238. 

Reserve ratio, changes in, 298, 320; 
as a guide for rediscount policy, 
324-30; should be made more 
manageable, 342. 

Reserves, of member banks, 222-24; 
percentages for reserve and mem- 
ber banks, 225-27; gold, 227-30; 
to be held entirely with reserve 
banks, 231, 232; surplus of re- 
serve banks, 323. 

Reynolds, Arthur, 246. 

Sectionalism, and the regioiial plan, 

5. 8-14. 
Senatorial Banking Committee, 

240. 
Short-time paper, in open-market 

operations, 190. 
Silver dollars, melting down of, in 

accordance with Pittman Act, 

212-14. 
Single-name and double-name paper, 

75-82, 108-11. 
Speculation, reserve funds used in, 

15 w.; land, 133, 134, 151; boom, 

315. 
Speculative paper, objections to re- 



discount of, 72-75; criterion of, 

85-93. 

Sprague, O. M. W., quoted, 80, 324. 

State banks, conditions for member- 
ship of, in the Federal Reserve 
System, 52, 53; unwillingness of, 
to join Federal Reserve System, 
54; doubtful legal position of, 55, 
56; question of double liability of, 
56; on rediscountability of paper 
held by, 57-59; other reasons for 
unwillingness, 59-64; increased 
membership, 65-67; considerations 
on membership of, 67-69. 

Stewart, Walter W., 280. 

Stokes, E. C, quoted, 310, 311. 

Strong, Governor, 58, 219. 

Syndicate acceptance, 175-80. 

Ter Meulen, 180. 

Thralls, Mr., quoted on the Hard- 
wick Amendment, 40. 

Timber, 86, 87. 

Time items, collection department 
for, 44, 45. 

Tractor paper, 138. 

Trade acceptances, operating in 
same manner as check, 109; ad- 
vantages urged in behalf of en- 
couraging use of, 111-14; means 
employed to extend use of, 115; 
origin as distinct class of commer- 
cial paper, 115; qualifications to 
which it must conform, 115, 116; 
why drawn in form of draft, 116; 
comparative amount of, dis- 
counted, 117; obstacles in the way 
of wide extension of its use, 118- 
20; aid to, justified, 120; objec- 
tionable methods of using, 120- 
23; in renewals, 122; on strength 
of firms whose allegiance to, was 
sought, 123, 124; used relatively 
infrequently, 125; limitations re- 
garding amount of, 125-27. 

Trade credit, historical causes of 
present methods of, 107. 

Trade paper, provisions pertinent 
to, no. 



352 



INDEX 



Treasury certificates, short-term, is- 
sues of, in the War, 267, 268; short- 
time fiscal requirements of, 300. 

Two-name paper. See Double-name. 

Wages, 305. 

War, the Great, effect on finances, 
240-42; effect of, on operations 
of member banks, 276, 277; con- 
ditions following, 292-97. 

War finance, successful and unsuc- 
cessful, 284-91. 

Warburg, Paul M., 65; quoted on 
trade acceptances, 80, 81; on the 
contrast between European and 
American banking methods, 107; 



on trade acceptances, 118, 119; on 
quoting forward discount rates, 
189; on the storing of gold, 228; his 
appointment to Federal Reserve 
Board, 240. 

Warrants, 194, 250. 

Williams, John Skelton, quoted on 
speculative use of reserve funds, 15. 

Willis, H. P., quoted on central 
bank, 8. 

W^ilson, President, 240. 

Withers, Hartley, 244. 

Youngman, Anna, her objection to 
open-market operations, 196-200; 
on rate increases, 340. 



